By now, you should be fairly well-versed in theoretical options trading. By well-versed, we mean you’ve learned enough about the principles and strategies to hopefully make steady gains (and not have to endure any major losses).
In unrestricted hands, options can be akin to a bull in a china shop; however, with proper utilization of the strategies we outline in this series, we are confident you will be able to (slowly, but surely) grow a small portfolio into a large pool of assets.
The last thing you want to do is go “YOLO” into options, because you’ll see your capital drain a lot faster than if you are on a mass speculation spree with common stocks.
To pre-emptively prohibit the bull from destroying thousands of dollars of antiques, we are going to dive into part 4 of our options Edge-ucation series, highlighting the bull spread strategy.
There are two types of spreads: bull spreads and bear spreads. As you can imagine, a bull spread is used to benefit from a stock moderately increasing in price, while a bear spread is used to benefit from a moderate decrease.
Within the two types of spreads, there is the option to use calls or puts.
A bull spread can be broken down into two options: a bull call spread and a bull put spread.
The same goes for bear spreads.
Today we are going over bull call spreads and bull put spreads.
A bull spread is a strategy involving buying an option and selling an option at the same time. Like a straddle, the expiry date and underlying stock are the same, though in a spread, the strike prices are different.
The general idea of a spread is to enter an options contract at an exceptionally low cost, and reap a calculated, limited return while exposing yourself to as minimal risk as possible.
Let’s dig a little bit deeper into it.
How It Works
The strategy for a bull call spread is to engage into 2 call options.
First, you purchase an out-of-the-money call option for a stock you are bullish on. Second, you sell a call option with the same expiry date, but at a higher strike price than the call option you bought.
Here’s what’s happened so far:
1. You’ve paid a premium for a call option you bought; the cost of which has been (mostly) offset by the premium you collected from the call option you sold.
2. You have created your maximum profit spread. The difference between the lower strike of the call option you bought and the higher strike of the call option you sold, is going to be your maximum profit.
Although the upside to this strategy is limited, your downside is limited as well, which is the appeal for any risk-adverse investor, or someone who is just getting into options trading and doesn’t want to risk blowing their portfolio!
Plugging some numbers in, let’s run through a scenario in which your prediction was correct, and your stock went up in price.
Bull Call Spread
You feel like ABC Inc. will increase in price. It’s currently sitting at $10/share. You engage in a bull call spread by buying a call option with a strike price of $12 and selling a call option with a strike price of $16.
The premium you paid for the $12 call option is going to be a little more than the premium you received for selling the $16 call option, due to the $12 strike being closer to the “money,” so your entry price for this strategy is not zero, but it is less than if you just bought a call option. However, your upside is now limited, unlike if you just bought a call option, where the upside has no limit.
This is because of how the options would pan out should ABC Inc. move past $16 (which is the goal).
Once ABC is “in-the
If ABC Inc. was trading at $20/share, you can exercise your right to buy the $12 shares and sell them for $20, right?
Not so fast.
At the same time your call option expired, and you exercised your right to buy the shares of ABC Inc. at $120; the call option you sold (or wrote, in options terms) will also be exercised, meaning the person who bought the call option off you will now be looking to buy shares of ABC Inc. for $16, that YOU are required to sell to them.
If you engaged in 10 contracts for each of the options in your bull call spread, it means you are controlling 1000 shares with each option.
After exercising your right to buy 1000 shares of ABC Inc. for $12,000, you will now have the obligation to sell 1000 shares of ABC Inc. to the $16 call option buyer for $16,000 (who will now likely look to sell his/her shares at ABC Inc.’s current market price of $20 for another $4,000 profit).
You have now pocketed $4,000 (before commissions), and paid a small premium to do so, the brunt of which was discounted by the call options you sold.
If the stock price of ABC didn’t ever exceed $12, you would have lost the premium you paid for the call option, though this is your maximum loss. If the price of ABC Inc., floated between $12-$15, never hitting the second options’ strike, you would be able to profit from the difference. One key thing to remember with this strategy is that your upside is capped at the second options’ strike price ($16), at a cost basis of the first options’ strike price ($12).
Bull Put Spread
A bull put spread involves finding a stock you think will move up, writing an out-of-the-money put at a strike price higher than market, and collecting a premium for the obligation to buy those shares from the put holder.
To insure your bet, you will also buy an out-of-the-money put option at a lower strike price and pay a (smaller) premium for the right to sell the shares to the put writer.
The two puts should be the same company, same expiry, with different strikes.
You have now received a premium for writing the higher strike put, and also paid a premium for buying the put with a lower strike.
Let’s use DEF Inc. as an example. It trades at $10/share. You suspect it may move higher, so you will write a put with a $10 strike. This will pay you a premium upfront.
To complete the bull put spread you will buy a put option at a lower strike; we’ll use $8 in this example.
Unlike calls, strategies involving puts are typically meant to pay you a premium upfront. The premium you receive by writing the put is slightly reduced, due to buying the lower strike put; however, this is a small price to pay to avoid the pricey obligation of fulfilling your assignment on the put you wrote.
In your ideal scenario, the price of DEF Inc. moves up past $10 (to $12, for example) by the time expiry approaches. The person who bought the $10 put from you will not exercise, as they would not want to sell a $12 stock for $10. The $8 put you bought is also worthless, leaving you with your net premium (the premium you received for the $10 put you wrote, minus the premium you paid for the $8 put you bought).
In a less than ideal scenario, DEF Inc. is $9 near expiry. You may have to fulfill the obligation to buy the shares from the put holder at $9, so they can go ahead and exercise their right to sell it at $10. This would however, cost commission and also require you to deploy capital.
The preferable strategy would be to close the put option by buying a put with the same strike and expiry. This would offset your position and cost you an amount that roughly equates to the price you received for the premium, therefore putting you in the ballpark of breaking even.
In the least favorable scenario, DEF Inc. moves to $6 a share, $2 below the put you bought. While the $10 put option that you wrote will now have to be offset at a loss, the $8 put you bought will now be in-the-money. This will provide you a profit to minimize the loss you experienced.
In short, a bull call spread creates a controlled range of profit in which your upside is limited to, however limits any major losses that may occur.
The bull put spread earns you a premium upfront that you ideally get to keep, aside from the small price you pay to cut your losses by purchasing a put option with a lower strike.
Note: You’ll notice in some scenarios we outline the act of exercising the options, and some we outline the act of simply buying and selling the contracts. The reality is, both methods roughly provide you the same result. Exercising your options and trading those shares instantly, versus flipping the option contract tend to be of equal value, due to the way option prices are set up.
Until next time,