In a bull market, stocks are trending upwards, and investors are often trying to place trades that would benefit from rising prices. Option strategies have defined parameters that allow you to express specific views on the markets.
An option gives you the right but not the obligation to buy or sell an underlying asset at a specific strike price on a future expiration date. Although options are tradable on many assets, the article covers options by stocks and how to trade bull spreads using options.
Understanding Bull Spreads
Investors with a bullish view that expect somewhat limited price increases might use bull spreads to potentially profit from rising prices. Bull spread trades can be placed using calls or puts.
A call option gives the buyer the right to buy a stock at the strike price by expiration, and a put option gives the buyer the right to sell a stock at the strike price by expiration. The cost of the option is the option premium.
In a bull spread trade, you choose different strike options to buy and sell, which changes the premium paid or received. Combining options allows you to express specific views on timing and price action.
How the Bull Call Spread Works
A bull call spread involves buying a lower strike call and selling a higher strike call option that expires on the same date.
Let’s say you expect the price of Apple stock to rise within the next two months, but not substantially. If the stock is trading at $100, you might pay $4 for a $105 strike call option and sell a $110 strike call and collect $2. Both expire in two months.
Formulas for Bull Call Spread
The defined parameters of bull spreads mean that you can calculate scenarios like maximum profit and loss using formulas.
Theoretical Maximum Profit and Loss
Your maximum profit occurs when the stock rises to the strike price of the short call option at expiration.
Maximum profit = short call strike price - long call strike price - long call premium + short call premium
Maximum loss occurs when the stock trades below the lower (long) call strike price at expiration. It is the net option premium paid.
Maximum loss = long call option premium - short call option premium
Example of Using Bull Call Spread
You may consider using a bull call spread if buying the lower strike call is expensive and you don’t expect the stock price to rise much above the upper call strike price. Or perhaps you are willing to give away upside above the upper call strike price to fund the option premium you have to pay.
In the example with the Apple stock, your maximum loss is the net premium paid to setup this position, which is $200, ($2*100=$200). Your maximum profit is the difference between the strike prices minus the net premium, which in this case is $300, ($3*100=$300) for the spread.
How the Bull Put Spread Works
A bull put spread involves buying a lower strike put option and selling a higher strike put option that expires on the same date.
Let’s say you expect the price of Apple stock to rise within the next two months, and you believe it will not fall below the lower strike price. If the stock is trading at $100, you might pay $4 for a $95 strike put option and sell a $98 strike put and collect $6. Both expire in two months.
Formulas for Bull Put Spread
After you choose your strike prices and understand the option premium costs, you can easily calculate your maximum profit and loss on the trade.
Theoretical Maximum Profit and Loss
You collect maximum profit when the stock stays above the strike price of the put option. It is the net option premium received.
Maximum profit = long put premium + short put premium
Maximum loss occurs when the stock trades at the lower (long) put strike price.
Maximum loss = (higher strike price - lower strike price) - (long put option premium + short put option premium)
Example of Using Bull Put Spread
If you think that Apple stock will not fall in the next two months, you may consider selling a put spread expiring in two months. In the $200 ($2*100=$200) previous example, your maximum profit is the net option premium collected, which is $2 per contract.
Possible Advantages of Bull Spreads
Bull spreads allow you to express specific trading views and have the following advantages:
Limited Risk
Your theoretical maximum loss on bull call spreads is the premium paid to buy the options.
Alternative Positioning
Instead of putting on a long position that could risk loss,of owning the stock your maximum loss is calculated according to the options strategies.
Flexibility
You can choose the strike prices and customize the option strategy according to the risk you’d like to take.
Things to Consider with Bull Spreads
Before putting on a bull spread, traders should consider the following factors:
Market Outlook
Before putting a bull spread into action, think about your market outlook. It's important to assess whether you anticipate the underlying asset to increase moderately. A bull spread works best in a stable or slightly bullish market since it caps both potential profits and losses.
Expiration Dates
Pay attention to the expiration dates of the options involved in the bull spread. Selecting the appropriate time frame can significantly impact the strategy's success, as options closer to expiration tend to have a higher time decay. It's important to consider how much time you’ll need for the anticipated price movement to occur.
Strike Prices
Be strategic when selecting your strike prices. The spread width (the difference between the buying and selling options' strike prices) has an impact on both potential profits and risk levels. A narrower spread can lead to lower potential profits but needs less movement in the underlying asset, whereas a wider spread allows for higher profit potential, albeit with a greater risk of loss.
Premium Costs
Keep track of the net premium involved when entering the bull spread. The initial expense of the spread will affect your overall profit. Make sure the cost fits with your risk management plan and anticipated price changes.
Volatility
Examine the volatility of the underlying asset, as it can affect the performance of the bull spread. Increased implied volatility may raise the costs of purchasing options, whereas decreased volatility could lead to lower premiums. Grasping the relationship between volatility and your strategy is essential for optimizing potential returns.
Discover Bull Spread Strategies
Bull spreads allow traders to express very specific views on the timing and price direction of the underlying asset. You can choose strike prices depending on what levels you think a stock will trade at by its expiration date and adjust your maximum profit and loss accordingly.
Frequently Asked Questions
How does a bull spread work?
A bull spread is an options trading strategy where you buy and sell options at different strike prices, aiming to profit from a moderate rise in the underlying asset’s price. This approach helps to limit both potential gains and losses, making it a more cautious option for those expecting a bullish market.
Is bull put spread a good strategy?
A bull put spread is a useful strategy for those with a positive outlook on the underlying asset. It helps to manage risk while possibly generating income. This strategy consists of selling a put option at a higher strike price and simultaneously buying another put option at a lower strike price, which helps to minimize both margin requirements and risk.
What is the downside of a bull call spread?
A bull call spread has the disadvantage of capping potential profits at the strike price of the short call. Furthermore, if the underlying asset’s price doesn’t exceed the long call’s strike price, this strategy may lead to a loss of the premium paid for the options.