Bull call spread: a beginner’s guide to options trading

Options trading offers a diverse range of strategies that allow investors to take advantage of market movements while managing risk. A commonly used tactic is the bull call spread, favoured by traders anticipating a gradual rise in the price of a stock or index. This strategy is a valuable tool for those looking to invest in stock market opportunities with a measured approach. 

In this article, we'll explore what is bull call spread, how it works, and when it might be the right strategy to use.

What is a bull call spread?

A bull call spread is a type of vertical spread strategy that involves buying and selling call options with the same expiration date but different strike prices. An investor uses this approach by purchasing a call option with a lower strike price and, at the same time, selling a call option with a higher strike price. Given that both options share the same expiration date, this approach is referred to as a "spread" strategy.

The primary objective of a bull call spread is to capitalise on an increase in the underlying asset's price while also managing and restricting potential losses. The premium received from selling the higher strike call helps offset the cost of purchasing the lower strike call, making the strategy more cost-effective compared to simply buying a call option outright. 

How does the bull call spread strategy work?

To better understand how the bull call spread strategy works, let’s break down its components:

1. Buying a call option (lower strike price): This is the first step in the strategy. The investor purchases a call option with a lower strike price, which gives them the right to buy the underlying asset at this price. The premium paid for this option represents the initial cost of the strategy.
2. Selling a call option (higher strike price): Simultaneously, the investor sells a call option with a higher strike price. This option requires the investor to sell the underlying asset at this price if the buyer chooses to exercise it. The premium received from selling this option helps to offset the cost of buying the lower strike price call.

Let’s consider an example to illustrate this:

Example scenario:

• Underlying asset: ABC stock
• Current price of ABC stock: ₹100
• Lower strike price: ₹95 (Call option premium paid: ₹7)
• Higher strike price: ₹105 (Call option premium received: ₹3)

In this case, the investor spends ₹7 to buy the ₹95 call option and earns ₹3 from selling the ₹105 call option. The net cost of the bull call spread is ₹4 (₹7 - ₹3).

Potential outcomes at expiration

• If the stock price is below ₹95: Both options expire worthless. The investor loses the net premium paid, which is ₹4. This is the maximum loss.
• If the stock price is between ₹95 and ₹105: The lower strike call gains value, while the higher strike call may be exercised. The net profit or loss will vary based on the stock's closing price.
• If the stock price is above ₹105: The lower strike call is exercised, allowing the investor to buy the stock at ₹95. However, the higher strike call is also exercised, requiring the investor to sell the stock at ₹105. The profit is capped at ₹6 (₹10 gain minus ₹4 cost).

When should you use a bull call spread?

The bull call spread strategy works best when you expect the price of the underlying asset to increase moderately. This strategy allows you to participate in the potential upside while limiting your downside risk.

Ideal market conditions for a bull call spread

1. Bullish market sentiment: If you expect the stock or index to rise but not by a large margin, a bull call spread can help you capitalise on this movement without the high cost of buying an outright call option.
2. Low volatility environment: In periods of low market volatility, option premiums tend to be lower, making the bull call spread strategy more cost-effective. Additionally, the limited upside potential of this strategy aligns well with the low-expectation environment.
3. Defined risk tolerance: Investors who are cautious about risk may find the bull call spread strategy appealing due to its predefined maximum loss. This makes it a good choice for those looking to manage their exposure in uncertain markets.

For example, consider an investor who believes that a particular stock will increase in value over the next few months but does not anticipate a significant rally. Instead of purchasing the stock or a single call option, the investor could use a bull call spread to limit the investment cost and cap potential losses. This strategy is particularly beneficial for those looking to invest in stock market opportunities with a balanced risk-reward ratio.

Benefits of the bull call spread

Like any investment strategy, understanding the benefits of bull call spread can help you decide whether this strategy aligns with your investment goals:

1. Cost efficiency: The bull call spread strategy offers a more economical way to establish a bullish stance compared to purchasing a call option directly. This is because the premium received from selling the higher strike call offsets the cost of buying the lower strike call.
2. Capped risk: The maximum loss is restricted to the total net premium paid to create the spread. This predefined risk can be appealing to conservative investors.
3. Profit from moderate moves: The strategy allows you to profit from moderate increases in the stock price without needing a significant upward movement.

A balanced strategy for market gains

The bull call spread is a strategic approach to options trading that allows investors to profit from moderate market gains while controlling risk. However, it's essential to understand the potential risks and rewards before implementing this strategy.

For those looking to explore options trading further and invest in stock market opportunities with a well-defined strategy, the bull call spread strategy offers a balanced approach. Ventura Securities provides the tools and insights needed to make informed investment decisions in future and options stocks and to develop strategies that align with your financial goals.