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Bull Call Spread Option Strategy

Bull Call Spread Option Strategy

What is Bull Call Spread Option Strategy?

  • A Bull Call Spread is created when the underlying view on the market is bullish, but not extremely bullish. Bull Call Spread option strategy is a net debit strategy with limited risk to limited reward, that is executed by buying a call and selling a higher strike call to fund it and reduce the execution cost, it should not be executed when we have extreme bullish bias and expect a run-away rally, as profit is capped on the upside.

When to Execute Bull Call Spread Option Strategy?

  • Bull Call spread option strategy is executed when we have bullish outlook in Index (like Nifty, BankNifty or FinNifty) or F&O Stocks, in near term. Instead of buying naked calls with higher outflow, one sells higher strike calls to partially fund the outflow resulting in hedged option trading strategy. Identifying clear uptrend is essential for the bullish strategy, specifically can be implemented on breakout which helps to get the momentum, on the other hand risk is limited and will not hurt much if breakout fails to materialise. Ideal scenario to execute bull call spread is when we are expecting gradual rise in price till the sold strike price, then we can earn premium in buy call and we can have theta benefit in sold call option too.

What is the Trade?

  • Buy one lot (At-The-Money) ATM Call and Sell one lot Out-of-Money (OTM) CE. Both the Call should be of the same underlying and expiration. This is the most commonly used combination.
    Breakeven for Bull Call Spread: Breakeven point = Buy Call Strike Price + net premium paid.
    Alternatively: Buy one lot In-the-money (ITM) call option and Sell one lot Out-of-the-Money call option.
    Also, Buy one lot Out-of-the-money (OTM) call option and Sell one lot Out-of-the-Money call option.
    Different strikes selected would result in different payoffs and it depends how quickly the target comes in, results in different reward: risk or profitability.

What will be maximum profit?

  • Maximum reward is limited to difference in strike less net outflow. Maximum Profit arises if the stock closes at or above the higher strike and flattens out, thereafter. Bull call spread options are benefitted by two factors, a rising stock price and time decay of the short option. A gradual price rise causes the written option to decay as time progresses and the value unlocking comes from the long option which increases in value when the underlying rises.

What will be your maximum loss?

  • Maximum risk is limited by the difference in cost of buy position of calls and sell position of calls, which is net premium.

What are the advantages?

  • Helps to participate in a bullish stock with relatively low cost. Reduced risk, cost, and breakeven point for a medium- to long-term bullish trade as compared to buying a call alone. Capped downside (although still 100% of the outlay). Only a purchase of a naked call means, expectation of a rapid bullish move in Nifty or the underlying, but if the bullish view going to take time to materialise, then the contrary position in call option of a different strike can help protect the overall NSE option strategy from a drop in time value of the option. (also, referred to as theta decay, in options Greek terminology).

What are the disadvantages?

  • Capped profit if the stock closes above short Call. Identifying clear areas of resistance and selection of strike becomes very important.

Example for Bull Call Spread

  • Nifty future fair price 2 Feb 2023 is 18200.
    A Bull Call Spread can be devised by adding
    one lot of 18200 CE At-the-Money (ATM) 2 Feb 2023 @148.90
    selling one lot of 18300 CE (OTM) 2 Feb 2023 @ 101.75.
    Net Premium Paid or Received = Rs. (-47.15).

Upon expiry:

  • Maximum profit above 18300 i.e., 100-47.15 = 52.85. i.e., difference between 18300-18200 = 100 - 47.25 (net premium paid). Maximum Loss = -47.25 (i.e., net premium paid) below 18200.
    Lot size = 50
    Max profit = 52.85*50 = Rs 2643/-
    Max Loss = 47.15*50 = Rs 2358/-

Impact of volatility on Bull Call Spread

  • As volatility rises, option prices rise, if other factors such as underlying price and time to expiration remain constant. Since a bull call spread Strategy consists of one long call and one short call, the price of a bull call spread changes very little when volatility changes. The portfolio Vega in the discussed example shows about 30/50 (50 stands for lot size), which is marginal, i.e. 0.6, (while that of individual leg is about 585/50 =11.7).
    Note: Bull Call Spread is a near-zero gamma option strategy.

Impact of time decay on Bull Call Spread

  • The time value of an option's total price decays as days to expiration decrease. This is known as time decay. Since a bull call spread strategy consists of one long call and one short call, the theta decay depends on the positioning of the underlying price to the strike prices of the spread. If the underlying price is “close to” or below the strike price of the long call (lower strike price), then the price of the bull call spread decreases with passing of time. This happens because the long call is closest to ATM and decreases in value faster than the short call.
    However, if the stock price is near to or above the strike price of the short call (higher strike price), then the price of the bull call spread increases with passing time (and makes money). This happens because the short call is now closer to being ATM or is ATM and decreases in value faster than the long call.
    If the underlying price is in between the strike prices, then time value decay or theta decay has little effect on the price of a bull call spread, because both the long call and the short call would decay at approximately the same rate.