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A call option is a derivative product that gives the buyer an option, but not an obligation, to buy a security from a seller at a predetermined price before the expiry of contract. To maximise the profits, some traders buy these call options in strategic proportions under a well-managed plan called options trading strategy.
A ‘bull call spread’ is also an options trading strategy that helps the trader to benefit from a stock's moderate increase in price. The strategy makes use of two call options to make a range comprising a lower strike price and an upper strike price. This helps to cut down on cost incurred in owing the stock.
Essentially, there are three steps involved in the bull call spread:
A. A trader first zeroes in on a security that is likely to witness a moderate increase in price over a period of time.
B. Then the trader will buy the call option with a strike price higher than the market price. Here the trader will pay a premium
C. At the same time, the trader will also sell a call option at a premium with an even higher strike price and the same expiration date as the first call that has been bought. In this case, the trader will collect the premium.
The premium received by selling the call will partially take care of the premium paid to buy the call. So, the difference between the two call options is the cost incurred in the options strategy.
Essentially, traders use the bull call spread when they expect the security prices to grow moderately and not substantially, and also when the stock prices experience volatility.
At the time of expiry of option, if the market price of security slides below the lower strike price, the trader will not exercise the option. The trader, as a result, will suffer loss to the extent of net premium paid to acquire the options. At the same time, if the stock price jumps higher than the upper strike price, the trader will exercise the buy call, enabling them to buy shares at a price lower than the market price.
The gain earned will be the difference between the lower strike price and higher strike price minus the net premium paid.
So, a bull call spread is a good options strategy that limits the risk incurred in call options purchased. At the same time, disadvantage in the strategy is that the gains, too, are capped up to the difference between the two strike prices.
This story was first published on MintGenie and can be accessed here.