Bull Call ( Debit ) Spreads
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Bullish Option | Risk Defined
Bull Call Spread ( Call Debit Spreads )
Learn how to set up and profit from Bull Call Spreads
A bull call spread is an options strategy that consists of buying a call option while also selling a call option at a higher strike price.
- Sell a call at a higher strike price
- Buy a call at a lower strike price
- Both options must be in the same expiration cycle.
Buying call spreads is similar to buying calls outright, but less risky due to the premium collected from the sale of a call option at a higher strike. As the name suggests, a bull call spread is a bullish strategy, as it profits when the underlying stock price rises.
Creating a spread defines the risk of any trade. In this case, creating the bull call debit spread defines the risk of a long call. In this case, selling a call to collect premium will decrease the amount paid to purchase a long call option. The strategy will, however, decrease you maximum profit potential.
Buying a long call is an extremely bullish option strategy. This is because the odds makers have already manipulated market conditions by raising premium prices for what they consider to be the expected movement of the stock.
Because a long call only makes money if the price of the stock moves above the break even price, and the break even price is established by the premium paid plus the strike price, the bet is already set up against you unless you have an “edge” that is not already baked into the price.
By creating a spread by selling a call for premium, you are decreasing the cost basis of the option as well as lowering the break even price, but at the expense of maximum profit.
The best stock movement scenario = ( believe it or not ) is for the stock to move in your favor and blow by above your short strike.
The short strike would lose all of its value, but this is offset by the profit of the ITM in the money long options. You would collect the maximum profit of the ( strike width + the premium received ) or 10+5 = 15.
If the stock moves in your favor and moves above the short strike, you will achieve maximum profit. The maximum profit is calculated by the width of the strikes minus the debit you paid.
In this example, the width is 10 and the debit it 5. So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.
If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade. Maximum loss is simply the price of your debit premium. In this case it is 5 dollars.
You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.
Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread. This adjustment will lower the cost basis even if you continue to expect to lose money on the trade.
If the original debit was 5 dollars and you were able to get another 30 cents. Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.
If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed. Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide. Your profit is based now on a strike width of 5 minus the debit which is now 4.7.
If the stock price does not move at all, the short strike will expire worthless and you would keep the premium.
The long call is simply the change in the value of the stock, which in this case has not changed.
So the value of the option is the profit of the premium that was sold. 5 dollars.
Note that you can manage this trade by moving the short strike ( for a profit ) toward the stock price if you can get a credit and you remain bullish on the trade.
Buying a naked call has negative theta. The option loses value as the option approaches expiration. The loss in value increases faster as time expires.
Selling a call has positive theta. The option benefits from time as it approaches expiration. The option price will decrease allowing us to buy the option back at lower and lower prices as the option approaches expiration.
Nothing breaks a multi-leg options trading strategy more than having one or more short leg assigned. Before you walk away with the idea that being assigned is a bad thing, it is not. When a short position is assigned, all extrinsic value in the contract evaporates in one shot, allowing you to make the full extrinsic value as profit without waiting until expiration. However, such an assignment may dramatically change the nature of a multi-leg options strategy.
If VISA rallies to $83 and the short Jan80 Calls get assigned, you would end up with a short 100 shares of VISA and long 1 contract of Jan75Call which creates a synthetic long put (Read our tutorial on Synthetic Positions). Compare the risk graph of a synthetic long put (which is the same as a long put) and the risk graph of a Bull Call Spread below:
Yes, as you can see, the assignment transformed the position from a bullish options strategy into a bearish options strategy. If you are of the opinion that VISA is going to at least pullback for the short term after such a strong rally, then its ok to hold on to that resultant position but if you simply want to trade it as a Bull Call Spread, then you would have already attained its maximum profit potential as there is no more extrinsic value remaining on the assigned short call options and the long call options have already exceeded the strike price of the short call options.
In this case, to close off the position, you would have to close out both legs as individual trades. Sell To Close the Jan75Call (which will also allow you to salvage whatever is remaining of its extrinsic value. If you exercised it, you would have lost these extrinsic value as well) and then Buy 100 shares of VISA to close the short VISA position.
At this point, legging becomes important if you want to make sure that the profits made are not lost in the process of closing the position due to untimely execution.
Buying a Call
Summary of Structuring a Debit Spread
- To structure a debit spread with a breakeven price near the current stock price, purchase an in-the-money option and sell an out-of-the-money option that are similarly distanced from the stock price. This type of spread will be similar to buying or shorting shares of stock, but with lower profit/loss potential and a higher potential return on capital.
- To structure a debit spread with low-risk and high return potential, buy an at-the-money option and sell an out-of-the-money option against it. This type of setup will have lower loss potential, higher profit potential, but more exposure to losses from time decay and a lower probability of success
- To increase the risk and reward of a debit spread, widen out the distance between the strike prices
- To reduce the risk of a debit spread, decrease the width of the distance between the strike prices
- Always be sure to check the premium of the short option in a debit spread. The short option in a debit spread is meant to reduce the cost of the long option. If the short option is too cheap, it doesn’t make sense to sell the option, as the premium collected doesn’t justify capping the profit potential
- As a general guideline, the short option should bring in premium equal to or greater than 20% of the long option’s price.
Buying a Call
How to Select Strike Prices for Debit Spreads
One of the difficult parts of learning how to trade options is getting comfortable with strike price selection for various strategies. At first, the amount of strike prices available can be overwhelming, but in time the process of selecting strike prices becomes natural.
There are two primary ways in which we structure our debit spread trades, which we’ll break down in this guide.
Selecting Strike Prices for Stock-Replication Debit Spreads
- This means we’ll aim to structure our debit spread to have a similar breakeven price as the current stock price.
- We use this type of spread when we want long or short stock exposure but with less loss potential and the opportunity for a high return on capital.
- To structure this type of debit spread, we purchase an in-the-money option and sell an out-of-the-money option.
- The long and short options should both be similarly distanced from the stock price. Here’s an example:
- Summary of Main Concepts
- To quickly summarize what this post has covered, here are the key points to remember:
- To structure a debit spread with a breakeven price near the current stock price, purchase an in-the-money option and sell an out-of-the-money option that are similarly distanced from the stock price. This type of spread will be similar to buying or shorting shares of stock, but with lower profit/loss potential and a higher potential return on capital.
- To structure a debit spread with low-risk and high return potential, buy an at-the-money option and sell an out-of-the-money option against it. This type of setup will have lower loss potential, higher profit potential, but more exposure to losses from time decay and a lower probability of success.
- To increase the risk and reward of a debit spread, widen out the distance between the strike prices.
- To reduce the risk of a debit spread, decrease the width of the distance between the strike prices.
- Always be sure to check the premium of the short option in a debit spread. The short option in a debit spread is meant to reduce the cost of the long option. If the short option is too cheap, it doesn’t make sense to sell the option, as the premium collected doesn’t justify capping the profit potential.
- As a general guideline, the short option should bring in premium equal to or greater than 20% of the long option’s price.
Buying a Call
Notes
The second type of debit spread setup we use is to structure a strategy with asymmetric return potential, but with less risk and a higher probability of profit than simply buying a call or put.
- The spread is structured by purchasing an at-the-money option and selling an out-of-the-money option against it. This setup will result in less loss potential, more profit potential, and a lower probability of success.
But how do you choose the short strike in the spread?
- That depends on your outlook for the stock. A logical placement for the short strike is your “best-case” scenario for the stock’s movement. In other words, the furthest you think the stock will move by the spread’s expiration.
- For example, the following spread uses a short strike of 130, which means the trader who buys this debit spread believes $130 is a realistic price target over the time frame of the trade:
- By altering our strikes to structure a more directional trade with better return potential and less loss potential, the potential return on capital increased in comparison to the previous spread. However, with more return potential and less loss potential, the probability of making money on the spread decreases
- In short, buying a debit spread with an at-the-money long option and an out-of-the-money short option results in less risk and more profit potential than a debit spread with an in-the-money long option. However, the more favorable risk/reward results in a lower probability of success because the stock price has to move by a certain amount in a specific direction
- If the stock doesn’t make that favorable move, the spread will lose money from time decay.
- Adjusting Strike Prices to Add or Reduce Risk
- Once you’ve determined the general structure of the debit spread you want to trade, the final step is to adjust the strikes to tweak the risk of the trade:
- 1. To increase the risk and reward of a debit spread, widen out the distance between strike prices.
- 2. To reduce the risk and reward of a debit spread, narrow the distance between the strike prices.
- The wider spread has more loss potential and more profit potential than the narrower spread.
- For smaller accounts targeting lower-risk trades, debit spreads with less distance between the strike prices can be traded. For larger accounts targeting higher-risk trades or a more efficient use of commissions, wider spreads can be traded. Adjust the strike prices until the spread meets your particular risk preference.
- Keep an Eye on the Short Option’s Price
- The last topic we’ll discuss is the price of the short option in the debit spread. The point of trading debit spreads is to gain bullish or bearish exposure with less risk and a higher probability of profit than simply buying a call or put. The downside of trading a debit spread as opposed to a call or put is that the debit spread has limited profit potential.
- Because of this, you’ll want to make sure the option you’re selling against your long option brings in enough premium to justify capping your profit potential.
- In this particular position, the short 145 call is only bringing in $0.40 in premium, which means the profit potential of the long 130 call is being limited by an option that’s only reducing the cost of the long call by $0.40 (a 5% in reduction the long 130 call’s price).
- In this scenario, it may not make sense to sell the 145 call at all. If you’re going to limit the profit potential of your long call by selling a call against it, then make sure the short option’s premium justifies limiting the profit potential.
- It will depend on the structure of the debit spread, but as a general guideline, the short option should bring in premium equal to or greater than 20% of the long option’s price.
- Summary of Main Concepts
- To quickly summarize what this post has covered, here are the key points to remember:
- To structure a debit spread with a breakeven price near the current stock price, purchase an in-the-money option and sell an out-of-the-money option that are similarly distanced from the stock price. This type of spread will be similar to buying or shorting shares of stock, but with lower profit/loss potential and a higher potential return on capital.
- To structure a debit spread with low-risk and high return potential, buy an at-the-money option and sell an out-of-the-money option against it. This type of setup will have lower loss potential, higher profit potential, but more exposure to losses from time decay and a lower probability of success.
- To increase the risk and reward of a debit spread, widen out the distance between the strike prices.
- To reduce the risk of a debit spread, decrease the width of the distance between the strike prices.
- Always be sure to check the premium of the short option in a debit spread. The short option in a debit spread is meant to reduce the cost of the long option. If the short option is too cheap, it doesn’t make sense to sell the option, as the premium collected doesn’t justify capping the profit potential.
- As a general guideline, the short option should bring in premium equal to or greater than 20% of the long option’s price.
Buying a Call
Summary of Structuring a Debit Spread
- To structure a debit spread with a breakeven price near the current stock price, purchase an in-the-money option and sell an out-of-the-money option that are similarly distanced from the stock price. This type of spread will be similar to buying or shorting shares of stock, but with lower profit/loss potential and a higher potential return on capital.
- To structure a debit spread with low-risk and high return potential, buy an at-the-money option and sell an out-of-the-money option against it. This type of setup will have lower loss potential, higher profit potential, but more exposure to losses from time decay and a lower probability of success
- To increase the risk and reward of a debit spread, widen out the distance between the strike prices
- To reduce the risk of a debit spread, decrease the width of the distance between the strike prices
- Always be sure to check the premium of the short option in a debit spread. The short option in a debit spread is meant to reduce the cost of the long option. If the short option is too cheap, it doesn’t make sense to sell the option, as the premium collected doesn’t justify capping the profit potential
- As a general guideline, the short option should bring in premium equal to or greater than 20% of the long option’s price.
Buying a Call
Profit and Loss Chart
- Max Profit Potential: (Call Spread Width – Net Debit Paid) x 100
- Max Loss Potential: Net Debit Paid x 100
- Expiration Breakeven: Long Call Strike + Net Debit Paid
- Position After Expiration:
If the long and short call are both in-the-money at expiration, the assignments offset, resulting in no stock position. If only the long call is in-the-money at expiration, the resulting position is +100 shares of stock per call contract.
- Assignment Risk:
Option Basics
How Does a Call Option Change with Volatility and Time
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
- Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
- Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
- Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
- Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega
Buying a Call
Management and Adjustments
- Maximum Profit Potential: Unlimited
- Maximum Loss Potential: Premium Paid for the Call
- Expiration Breakeven Price: Call Strike + Premium Paid for Call
- Estimated Probability of Profit: Less Than 50%
- Assignment Risk?
Option Basics
Tips and Tricks
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
Vertical spreads
allow for direction trading with defined risk
maximum profit loss known on entry
Prefer to sell premium in high IV environments, and buy premium in low IV environments.
When IV is high, we look to sell vertical spreads hoping for an IV contraction.
When IV rank is low, we look to buy vertical spreads to stay engaged and also use it as a potential hedge against our short volatility risk.
Adjustments
Since the maximum loss is known at order entry, losing positions are generally not defended.
We always look to roll for a credit in general, and doing so with vertical spreads is usually difficult.
Close Goal : 50% of maximum profit
Losing long vertical spreads will not be managed but can be closed any time before expiration to avoid assignment/fees.
Why learn options
Virginia Patients
Trade Management and Adjustments
strategies introduction blurb
strategies introduction blurb
strategies introduction blurb
Trending Articles on Options
Trending Articles
Our Program
Option Maniacs has been voted #1 in Northern virginia and the loudoun times mirror for multiple years in a row
Blurb
Free Consultation
Thousands
Fast results in minutes
Blurb
Blurb
Are you ready?
Get started by booking a free consult right away. The procedure itself only takes about 3-5 minutes and no downtime!
- 19500 Sandridge Way Suite 350 Leesburg, VA 20176
- 703-214-4823
- info@gotobeauty.com
Hours of Operation: M-Th 9am-5pm | Fri 9am-3pm | Closed Sat-Sun
