Breakdown of a Bull Call Spread

Here's an options strategy for those looking for modest upside with limited downside risk.
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Many investors are understandably worried about how long the stock market can maintain its remarkable resilience to the destruction and higher energy prices left in Hurricane Katrina's wake.

If you're still moderately bullish on a stock but are uncomfortable owning the stock outright, a bull call spread could be right for you.

A bull call spread is an options strategy that allows an investor to benefit from modest upside in a stock while limiting the downside risk. Some real-world examples are below, but for those unfamiliar with the strategy, here is a breakdown:

The Long and Short of It

The execution of the bull call spread trade involves both buying and selling of calls with the same expiration date. Let's review each side of the trade individually.

A long call is a bullish position and the most basic of all option strategies. When you are purchasing a call it gives you the right -- but not the obligation -- to purchase the underlying stock at a specific strike price on or before expiration.

A strike is the price at which an asset can be bought (for a call) or sold (for a put) by the option holder. The expiration date is when the options expire. (For a list of options definitions, please check out the

glossary for the

Options Alerts newsletter.)

When you purchase a call, you are hoping that the stock price moves up. As the stock moves higher, your profit possibility is unlimited. The most you can lose when purchasing a call is the amount you paid for it, so you have limited risk.

Now let's take a look at a graphic representation of a long call. The y-axis represents your profit and loss, and the x-axis represents the price of the stock.

Your long call position starts to make money after it crosses the x-axis, which is at the break-even point -- the strike price plus the amount paid (net debit) for the call. If the stock remains below the break-even point, the most you can lose is the premium you paid for the call.

Source: TheStreet.com

Now for the short call, which is a bearish position. When you short (or sell) a call you are giving someone else the right -- but not the obligation -- to purchase the underlying stock at a specific price on or before expiration. The maximum amount you can make selling a call is the premium, or price of the call, you have collected from the sale. The maximum risk is unlimited as the stock trades higher. The higher a stock trades the more money you lose.

Now let's take a graphic look at a short call. The y-axis represents your profit and loss, and the x-axis represents the price of the stock.

Source: TheStreet.com

Coming Together

Now let's look at how to develop a bull call spread by combining both the long call and short call positions into one trade.

The bull call spread involves the purchase of a call, usually more then four months until expiration. The other half of the trade is the simultaneous shorting of an out-of-the-money call on the same underlying stock with the same expiration month. (An option is considered at-the-money if the strike price of the option equals the market price of the underlying security. A call option is considered out-of-the-money if the stock price is below the strike price.)

This is an opening transaction, and you will trade the same amount of options for each strike. The purchase and sale can be done simultaneously through your broker. This trade is a net debit transaction, because the calls you purchased are more expensive than the further out-of-the-money calls you sold.

With this type of vertical spread, you will make money only if the stock trades modestly higher. If you are extremely bullish on the direction of the stock, it would be more profitable to just purchase the call outright. Whether the lower strike you purchase is at-the-money or slightly out-of-the-money depends on your outlook of the stock. If you have a more bullish outlook, you should purchase calls that are slightly out-of-the-money in order to have a chance for a greater return.

Here is the risk/reward of the trade:

The maximum risk is the net debit paid

The maximum reward is the difference between the two strikes minus the net debit

The break-even is the lower strike plus the net debit


Source: Options Industry Council

The above graph shows the bull call spread. You can clearly see that the break-even is the lower strike price plus your net debit. If the stock trades below the strike you are long, then the most you can lose is your net debit.

You start to make money on the trade when the stock trades above your net debit and reaches its maximum gain when the stock rises to the higher strike price. You are looking to capitalize on a modest advance of the underlying shares. The calls that you sold are capping your upside potential gains ,but at the same time they are reducing your break-even and cost basis.

Let's take a look at a few examples of executing a bull call spread.

Schering-Plough

(SGP)

is trading near its 52-week high, and let's say you think it will break through to make new highs.

Schering-Plough was recently trading at $22.28: To initiate the bull call spread trade you would buy the January 2006 22.5 calls for $1.30 and sell the January 2006 25 calls for 40 cents. Your maximum risk is your net debit of 90 cents: the price of the 22.5 calls ($1.30) minus the price of the 25 calls (40 cents). Your maximum reward is $1.60, or the difference in strikes ($25 minus $22.50 = $2.50) minus the net debit of 90 cents. Notice how your maximum reward is greater than your net debit and maximum risk. Your break-even point would be $23.40, or the lower strike price of $22.50 plus the net debit of 90 cents.

Dell

(DELL) - Get Report

was recently trading at $34.65. To initiate the bull call spread you would buy the January 2006 35 calls for $1.95 and sell the January 2006 37.5 calls for 90 cents. Your maximum risk is your net debit of $1.05: the price of the 35 calls ($1.95) minus the price of the 37.5 calls (90 cents). Your maximum reward is $1.45: the difference in strikes ($37.50 minus $35) minus the net debit of $1.05. Again, your maximum reward is greater than your net debit and maximum risk. Your break-even would be $36.05: the lower strike price of $35 plus the net debit of $1.05.

It is important to keep in mind that this is a net debit trade, so you need to remember what role time decay, or theta, will play on your positions. When you buy option premium, which is the price you pay for the option, theta will work against you. Theta measures the rate of decline in value of an option due to the passage of time. An option is a wasting asset. All things being constant, an option will lose value as it approaches the maturity of the option.

Time decay is beneficial to this position when the stock trades towards the higher strike and is profitable and harmful to the position when the stock trades down towards the lower strike. You want to buy the further out months, therefore giving yourself more time to be right.

When exiting the trade, you have a few options. You can simply sell out your long calls and buy back your short puts. You can also just leave one leg of the trade on and attempt to profit from one side. You can do this by either selling out the long call -- which would leave you with just a short call, or you could buy back the short call, leaving you with a long call.