While anyone can trade options by buying straight call or straight put options or selling naked call and naked put options, this method of trading is generally considered aggressive in nature. Traders can easily turn in a higher percentage of gain if they predicted the direction correctly, but they can also easily lose their shirts if the underlying asset moved against the position or stayed sideway. Buying straight calls and puts work well in very short-term trade – about 2 to 5 days. For trades that take between one to three months or longer, spread strategies are preferable.

There are four basic option spread strategies commonly used by traders and academics alike. These four option strategies are

• Bull Call Spread – A bullish debit spread
• Bear Put Spread – A bearish debit spread
• Bull Put Spread – A bullish credit spread
• Bear Call Spread – A bearish credit spread

Familiarizing with these strategies can certainly help you develop as a professional trader. No doubt these basic strategies sounded basic and common, they are definitely not unimportant or ineffective. On the contrary, they are by far the most preferred, profitable strategies in the options community. After many years of trying a wide variety of strategies, they are still the most practical and simple ones to execute in real trading. Novice options traders are strongly encouraged to try them as much as they can in their first year of trading. By the end of that year, you will understand what I mean here.

Here we will only explain the mechanics of the strategies. Later in separate article, I will tell you how to deploy them in the real trading situations. Now, let’s get down to it.

Bull Call Spread

Step 1: Buy lower-strike Call option
Step 2: Sell Higher-strike Call option with the same expiration date.

Characteristics
A Vertical Spread, this is a Debit transaction.

Investor Sentiment
Moderate Bullish Strategy (small debit spread):
It’s considered a bullish strategy because you profit if the underlying stock price increases.

Cost, Profit & Loss
Net debit = Higher_strike call options – lower_strike put options
Profit = Difference of strike prices – net debit (maximum; limited)
Loss = Net debit paid (maximum; limited)

Profit Potential
Maximum profit is reached if the stock price closes above the short (higher-strike) call option strike price on expiration date.

Risks
Maximum loss is reached if the stock price decreases below the long (lower-strike) call option strike price at the expiration date.

Drawbacks
Lower risk than strictly buying call options, but limited profit potential. Break even at lower strike price plus net debit. This is a debit spread position. That is, the amount of the sale of call option position brings in less than is needed to purchase the call option position.

How To Trade
You trade bull call spread in circumstances where you anticipate the underlying asset price to rise. Generally, you select the lower-strike option to be Near-The-Money of the underlying. The short side of the bull call spread involves you selling the higher-strike call option against the short one. You want to select a strike price that is

• High enough to create a decent upside; and
• Low enough so that the premium you’re selling does impact favorably upon the net debit, therefore, your risk and breakeven point.

The optimum time span to trade is about one to three months to expiration. Volatility of the short option is preferably higher than long one.

Bull Call Spread Example

Stock Company Name/Ticker Symbol: Intel Corp. (INTC)
Stock Price: $29.61
Buy Near-The-Money Call Option (Long position): 10 contract – Nov $30.00 @ $1.45
Sell Out-Of-The-Money Call Option (Short position): 10 contract – Nov $32.50 @ $0.50
Call Options Expiration Date: November (Third Friday of the month)

This position is considered a net debit of $0.95, for spread of $2.50. That is the difference between the sale of the out-of-the-money (higher strike) call option and purchase of the near-the-money (lower strike) call option which results in a negative cash flow of $0.95 ($1.45 - $0.50). The spread represents the difference between the in-the-money and out-of-the-money strike prices, which are $2.50 apart (Nov $32.50 call option - Nov $30 call option). So, what does all of this translate to for potential profit? Let’s assume the stock price is higher than the out-of-the-money (higher) call option strike price ($32.50) on November expiration date. That would translate to a maximum profit of the difference between the spread minus the net debit or $2.50 - $0.95 = $1.55 x 10 contracts (1,000 shares) for a maximum profit of $1,550 per 10 contracts. The percentage return becomes $1.55/$0.95 x 100% = 163%.

Now let’s look at the maximum loss potential should the stock price go below the lower strike price on November expiration date. When establishing our Bull Call Spread, we have pre-determined the maximum amount we are willing to lose in this option position. That maximum loss potential translates to the $0.95 net debit spread x 10 contracts (1,000 shares) = $950.

By using the Bull Call Spread strategy we have lowered our risk compared to only buying calls exclusively. If we bought the November $30 @ $1.50 call option outright and the stock price is lower than $30 on November expiration date, we would have a potential loss of $1.50 x 10 contracts (1,000 shares) = $1,500. This is a much more significant loss than the $950 potential loss using the Bull Call Spread strategy.

Next post will cover Bear Put Spread

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