When it comes to investing in the stock market, you can use plenty of strategies to try and boost your returns. Options give investors a way to take advantage of small price movements in the price of an underlying asset, such as a stock, index, or commodity. Essentially, options give the investor the right – but not the obligation – to buy or sell an underlying asset at a certain price (the strike price) by a certain date (the expiration date). Different types of options can be used in almost any market condition. One strategy that is useful for neutral market conditions is the bull call spread. A bull call spread is an options strategy that involves buying one set of call options while selling another with a lower strike price. This article covers everything you need to know about why and how to trade bull call spreads.

What is a Bull Call Spread?

A bull call spread is a vertical spread involving buying and selling (writing) the same type of options contract where both have the same expiry date. The key feature of a bull call spread is that the purchased call option has a higher strike price than the written call option. Bull call spreads are a bullish strategy and are used when you expect a moderate rise in the underlying asset's price over the life of the options. The goal is to earn a profit from the premiums received at the initiation of the trade and then the difference between the strike prices of the purchased and written call options. The purchased call option will have a higher premium than the written call option. However, the difference between the two premiums is less than the premium of the purchased call option since you will be selling the written call option at a higher premium. This is why you need to own the underlying asset to complete the bull call spread. The purchased call option and written call option act as a hedge against each other, smoothing out the risk of the trade.

How to Trade a Bull Call Spread

To trade a bull call spread, you buy a lower strike call option and sell a higher strike call option. For example, you could buy the XYZ Aug 20 Call option and sell the XYZ Aug 25 Call option. You will then earn the difference between the premiums of the two call options. The Aug 20 Call option has a strike price of $10 and a premium of $2.50. Meanwhile, the Aug 25 Call option has a strike price of $15 and a premium of $1.75. Your profit on the trade is the difference in premiums, which is $0.75. If the price of XYZ increases to $15, your profit on the Aug 20 Call option will be $15 - $10 = $5, while the Aug 25 Call option will expire worthlessly. This is because the higher strike price means it has no intrinsic value.

Benefits of Bull Call Spreads

- Planning ahead - Bull call spreads are a longer-term strategy since the options have a set expiration date. You can trade them like a regular option, but keeping the time horizon in mind is important. When you trade a bull call spread, you benefit from the time decay of the option premiums. The more time that passes, the more the option premiums will decay. This means you have more time to ride out market volatility and wait for the options to expire.

- High probability of profit: Bull call spreads have a high probability of profit. You will earn a profit as long as the underlying asset moves moderately higher. And even if the underlying asset does not move, it is still highly likely that the premium earned in the trade will be enough to cover the costs of the trade. You can use option trading simulations to figure out how likely your strategy is to make money.

- Low risk: Since you already own the underlying asset, you are not exposed to the full risk of the options used in the trade. This means that any market volatility during the life of the options is less likely to impact you.

- High reward-to-risk ratio: Bull call spreads have a high reward-to-risk ratio since they only buy a lower strike option and write a higher strike option. This limits your potential losses.

- Low capital requirements: You need to own the underlying asset for a bull call spread, which means you don't have to have a large amount of capital to trade this strategy.

- Trading without an opinion: The bull call spread is not a strategy that requires an opinion on the overall market. Instead, you are trading the movement of the underlying asset.

Limitations of Bull Call Spreads

- High capital requirements: You have to own the underlying asset for a bull call spread. This can require a significant amount of capital to purchase the shares in the first place.

- Requires a moderate increase in the underlying asset price: The purchased call option has a lower strike price than the written option, so it will expire worthless if the underlying asset doesn't move far enough to cover the difference between the strike prices. This means you will have to wait for a moderate increase in the underlying asset price.

- Time-based: The more time passes, the more the option premiums will decay. Suppose the underlying asset doesn't move enough to cover the difference between the strike prices. In that case, the premium earned in the trade will be less than the premium of the purchased call option. This means you will want to trade this strategy in a market that doesn't have a lot of volatility.

- Requires a long-term view: Bull call spreads are a long-term strategy since the options have a set expiration date. You can trade them like a regular option, but keeping the time horizon in mind is important.

- Relying on another option to give you full return: The purchased call option and the written option act as a hedge against each other, smoothing out the risk of the trade. This means that you will only get the full amount of profit if one option expires worthless.

- Risk of early assignment: The written call option has an early assignment risk, which means that the holder of the option can force you to sell the shares early if the underlying asset's price is above the strike price. This risk will be higher for the written option with a lower strike price.

- Risk of loss in the underlying asset: The purchased call option will have no intrinsic value if the underlying asset drops below the strike price.

- Limiting the upside of the underlying asset: The purchased call option will have no intrinsic value once the underlying asset reaches the strike price. This means you won't be able to benefit from the full upside of the underlying asset.

- Risk of a drawdown: If the underlying asset moves in the wrong direction, you could see a significant decrease in your account balance.

- Risk of a margin call: You have to maintain a minimum amount of equity in your account, and you risk having your account equity go below that minimum. This could result in a margin call, where your broker will ask you to add funds to your account to cover the shortfall.

- Risk of an unprofitable trade: The bull call spread is not a strategy that guarantees a profit. Instead, it is designed to limit your losses and increase your gains.

- Using leverage: The bull call spread is a leveraged strategy, which means it uses margin to amplify the gains and losses in your account.

- Risk of early closure: The options markets can close early due to adverse market conditions or economic events. This could result in an unprofitable trade.

- Waiting for the expiration of the options: You have to wait for the options to expire to collect your profit. This means you have to stay in the trade for the full term.

- Volatility of the underlying asset: Higher volatility means greater price swings in the underlying asset and greater price movements in the options. This can affect the amount of profit you earn in the trade.

Conclusion

Bull call spreads are a strategy designed for neutral market conditions. They are a long-term strategy that involves buying a lower strike call option and writing a higher strike call option. These options will have the same expiration date and be either at-the-money or out-of-the-money. This means that you will be trading the movement of the underlying asset. You will benefit from the time decay of the option premiums. The more time that passes, the more the option premiums will decay. This means you have more time to ride out market volatility and wait for the options to expire.