You're sort of bullish, but these days being a rip-snorting type of bull is dangerous. Even when you think a particular stock has good prospects, you can't help but be leery about purchasing it outright.
On the other hand, you'd take the leap if only you could get a hedge that would give you some cover.
Fear not prospective option investor, there's a strategy that might suit you just fine: the bull call spread.
A bull call spread is initiated when an investor buys a call option and simultaneously sells another call option with a higher strike price and the same
expiration date. But while a bull call spread limits risk, it also puts a cap on profit potential.
Buying calls -- or being long calls -- gives you the right to buy a stock at a certain price before a certain date and gets you some appreciation in the options' price if the stock rises. Selling the calls -- being short the calls --- with the higher strike price obligates you to sell shares of stock at that price if you are assigned at expiration.
The total risk in the position is the purchase of the lower strike call option, and the maximum profit in a bull call spread is the difference between the strike prices minus the amount you paid to establish the long call option side of the trade. Break-even on a bull call spread is the lower strike price plus the debit amount.
We'll use a position on
Applied Micro Circuits
as an example of a bull call spread. Shares of the company were trading at about $38 earlier this week.
To do a somewhat aggressive bull call spread on Applied Micro Circuits, you could buy the August 35 call at 12 1/4 ($1,225) and sell the August 50 call for 6 1/2 ($650) for a net debit of $575. That amount is the cost of putting on the bull call spread, excluding commissions.
The break-even point on this trade is $40.75. That's the sum of the lower strike price ($35) plus the debit to put on the spread ($5.75). The maximum an investor could make on this trade is 9.25 ($925), reached by subtracting the lower strike from the higher strike, and subtracting the debit from that amount.
Your gains will be capped because if the stock is at $50 or above at expiration, it's likely those options will be exercised and to fulfill the obligation associated with your sale, you'll have to deliver the appropriate amount of shares.
You fulfill your side of that trade by either delivering the shares you obtained by exercising the August 35 call you bought. That's a winner because buying a call entitles you to purchase AMCC shares at 35 no matter what the market price of the stock. But if you want to hold on to the shares to reap some more gains, you'll have to buy the August 50 calls back for a higher price than you sold them.
This isn't foolproof.
One options pro suggests that if you're going to initiate a bull call spread, you should make sure the call option you're selling is expensive enough to justify giving up the upside and the cost of paying the extra commission to do the trade, as compared to buying a call option outright.
The trader suggests that the best spreads are usually for options that expire further out on the calendar -- more than 30 or 60 days -- as opposed to front-month options. That way, the stock has enough time to move in the direction you want to make the trade worthwhile.
Also, keep in mind there are severities of bullishness when putting on a bull call spread.
If you want to get more aggressive, as in really aggressive, in the world of the bull call spread, you can buy
out-of-the-money calls, that is, call options with a strike price higher than the current share price.
Of course, doing a bull call spread with out-of-the-money calls increases the chances of the trade failing because the stock has to appreciate enough to push the long call position. The upside is that the position doesn't require the same cash outlay to purchase the calls.
Let's take another look at Applied Micro trading at around $38. An investor could buy the August 40 call for 9 7/8 ($987.50) and sell -- hey, why not -- the August 55 call for 5 1/8 ($512.50) for a net debit of $475. To break even, Applied Micro has to rise to $44.75 by August expiration, which occurs on Aug. 17.
The most one can lose on that trade is $475. The maximum profit is 10.25, or $1,025.
Sure, it's a risk, but these days if you can get a little cover on a stock you like, particularly in the tech sector, it may be worth it.