Bull Spreads - A Sophisticated Options Strategy Available to Novices
Many sophisticated investors will tell you that a bull spread is among the most conservative option strategies in practice.
However, for the novice options trader it may appear to be too exotic.
Trading spreads are the building blocks of many options trading strategies.
An options trader can create a spread position by buying and selling equal number of options of the same class the same underlying security but with different strike prices or expiration dates.
In the case bull spread, the options trader is banking on a moderate price increase in the underlying security.
As a result, a purchase will be made of an "at the money call" for the security.
At the same time, the trader will sell an "out of the money call" for the same security in the same expiration period.
As I said, the trader is banking on a moderate price increase in the underlying security.
If this assumption is correct, then the trader will make money on the call option which was purchased; and as long as price of the underlying security does not advance beyond the strike price of the option which was sold, the trader will be able to keep all of the profits from the options which were sold.
Example of a Bull Spread As is often the case, an example is a better way of illustrating option strategies.
As you may know, 1 option contract controls 100 shares of stock.
So if an option trader buys or sells an option, they are controlling 100 shares of the underlying stock.
Let's assume you believe that the price of stock ABC - currently trading at $100 - will go up by a few dollars in the next month.
As a result, you decide to create a bull spread.
Assume that for options expiring next month, a call option with a strike price of $100 costs $3 per share, or $300 per contract, while a call option with a strike price of $115 is selling at $1 per share, or $100 per contract.
So as per the strategy, you buy 5 option contracts at a strike price of $100, expiring next month.
This will cost you 5x$300=$1500.
You then sell 5 option contracts at a strike price of $115, expiring on the same day as the purchased options.
This transaction puts 5x$100=$500 into your account.
This $1000 differential represents your net debit - which is also the maximum possible loss on the trade.
Your maximum gain on the trade is always projected at the difference in strike price ($15) multiplied by the number of shares controlled (500) less the net debit ($1000).
So the maximum profit is $7500-$1000=$6500.
This trade results in a profitable trade if the stock closes on expiry above $102.
If the stock's closing price on expiration is $108, the $100 call option will end at a profit of $8 a share, or $800 per contract, while the $115 call option expires worthless and you keep the $500 made on the original sale.
Hence there is a gross profit of $4,000 (the value of the $100 call option), less $1000 (the net debit) which nets out to a $3,000 profit.
Again, the trade's profit is limited to $13 per share, which is the difference in strike prices minus the net debit (15 - 2).
The maximum loss on the trade equals $2 per share, the net debit.
And this is why many options traders consider the bull spread strategy to be conservative.
The investor entering into a bull spread is immediately aware of both the maximum loss and the maximum profit.
Of course knowing that there is a limitation on your maximum loss is nice, but options trading is about making profits.
And the keys to maximizing a profit in a bull spread is in the assumption that the underlying security involved will be subject only to a moderate price increase and over the shortest time possible.
On its surface, the bull spread options strategy appears to be a slow but sure way of making money.
However, if the trader is wrong regarding the assumptions of the underlying security, then he or she will find the bull spread option strategy to be a slow but sure way of losing.
However, for the novice options trader it may appear to be too exotic.
Trading spreads are the building blocks of many options trading strategies.
An options trader can create a spread position by buying and selling equal number of options of the same class the same underlying security but with different strike prices or expiration dates.
In the case bull spread, the options trader is banking on a moderate price increase in the underlying security.
As a result, a purchase will be made of an "at the money call" for the security.
At the same time, the trader will sell an "out of the money call" for the same security in the same expiration period.
As I said, the trader is banking on a moderate price increase in the underlying security.
If this assumption is correct, then the trader will make money on the call option which was purchased; and as long as price of the underlying security does not advance beyond the strike price of the option which was sold, the trader will be able to keep all of the profits from the options which were sold.
Example of a Bull Spread As is often the case, an example is a better way of illustrating option strategies.
As you may know, 1 option contract controls 100 shares of stock.
So if an option trader buys or sells an option, they are controlling 100 shares of the underlying stock.
Let's assume you believe that the price of stock ABC - currently trading at $100 - will go up by a few dollars in the next month.
As a result, you decide to create a bull spread.
Assume that for options expiring next month, a call option with a strike price of $100 costs $3 per share, or $300 per contract, while a call option with a strike price of $115 is selling at $1 per share, or $100 per contract.
So as per the strategy, you buy 5 option contracts at a strike price of $100, expiring next month.
This will cost you 5x$300=$1500.
You then sell 5 option contracts at a strike price of $115, expiring on the same day as the purchased options.
This transaction puts 5x$100=$500 into your account.
This $1000 differential represents your net debit - which is also the maximum possible loss on the trade.
Your maximum gain on the trade is always projected at the difference in strike price ($15) multiplied by the number of shares controlled (500) less the net debit ($1000).
So the maximum profit is $7500-$1000=$6500.
This trade results in a profitable trade if the stock closes on expiry above $102.
If the stock's closing price on expiration is $108, the $100 call option will end at a profit of $8 a share, or $800 per contract, while the $115 call option expires worthless and you keep the $500 made on the original sale.
Hence there is a gross profit of $4,000 (the value of the $100 call option), less $1000 (the net debit) which nets out to a $3,000 profit.
Again, the trade's profit is limited to $13 per share, which is the difference in strike prices minus the net debit (15 - 2).
The maximum loss on the trade equals $2 per share, the net debit.
And this is why many options traders consider the bull spread strategy to be conservative.
The investor entering into a bull spread is immediately aware of both the maximum loss and the maximum profit.
Of course knowing that there is a limitation on your maximum loss is nice, but options trading is about making profits.
And the keys to maximizing a profit in a bull spread is in the assumption that the underlying security involved will be subject only to a moderate price increase and over the shortest time possible.
On its surface, the bull spread options strategy appears to be a slow but sure way of making money.
However, if the trader is wrong regarding the assumptions of the underlying security, then he or she will find the bull spread option strategy to be a slow but sure way of losing.
