In an aggressive market, it can be easy to get carried away. The fear of missing out on the next big boom is the fear that causes reckless investing. And sure enough, as soon as caution is thrown to the wind, it seems, the market’s luck runs out. If this sounds like you, then you will be happy to hear there are intelligent ways to play a bullish (i.e. aggressive) market. Yes, a little conservatism comes with playing intelligently, so you’ll have to learn to reign in your inner-bull, but the reward is worth it: smart, effective, low-risk investing.
The strategy is called a bull call spread, which safe-guards you from extreme losses while turning a moderate profit. Learn others ways to invest intelligently with this essential options course on strategies for mastering the stock market.
Bull Call Spread Defined
True to its name, a bull call spread is a bullish option strategy. The primary goal is to limit the amount of the initial investment required for a call option by profiting from stocks that are growing, and expected to continue to grow, modestly. Compared to other types of investing, like bonds, this is a very short term strategy. Of course, picking stocks that are actually going to grow is vital, so avoid beginner’s mistakes with this stock selection mastery course.
Buying And Selling
A bull call spread works by playing two call options with the same expiration date. One call is purchased at a lower strike price, which at times can be nearly in-the-money, while another call is sold at a higher strike price, which will be further out-of-the-money than the first call. This ultimately makes it cheaper than buying call options on their own, and for this reason it is also known as a bull call debit spread.
The reason you use call options is because of your faith in the fact that stock is going to behave moderately. If you had convictions it was going to skyrocket, you would not use a bull call spread, which would put a ceiling on your profits through the nature of call options. Instead, you would simply buy the stock and ride it to the top. It is true that a bull call spread technically limits the maximum amount of profit you can turn, but you have to remember that you do not use bull call spreads like lottery tickets. The trade-off is a relative degree of confidence and security, and it is a testament to all the smart investors out there that bull call spreads are still extremely popular.
Another extremely similar option is the covered call, which is nearly identical to the bull call spread and provides a similar sort of protection. Check out the details in this article on covered calls and low-risk money making.
Example Investment: Part 1
This example will clarify the intelligence behind bull call spreads. Let’s say that a stock is trading at $50. A trader expects the stock to move up to between $55 and $60 over the next two months.
The first thing the trader will do is buy a call option. Remember that the option the trader buys is the one that is less risky, and because of this, it is more expensive. So because the trader expects the stock to go between $55 and $60, he will buy a $55 call option. Let’s imagine it costs him $0.70 per share. Because an option contract requires 100 shares, this will cost the trader $70.
The second thing the trader is going to do is sell a call option. He will sell 100 shares for a call option on the upper end of his predictions ($60). Let’s imagine this option, which is riskier and therefore not as favorable to the buyer, costs only $0.20 per share. Again, a call option for 100 shares will sell for $20. Please understand that the shares are not being sold for $20, just the option. The buyer is paying for the option to buy the shares at any point during the next two months for the predetermined price of $60 per share. If you help understanding call options, this post on call and put options explains the two most common and basic stock options.
Example Investment: Part 2
So, what does it cost our hypothetical trader to have a bull call spread? Easy: he bought one option for $60 and sold another for $20, thus it cost $40. Now that all the players are in place, how does this strategy make money?
Let’s say the stock, which started at $50, exceeded expectations and rose to $65. This is good news for our trader, but this is also where things can be tricky to understand. First, let’s ignore the fact that our trader owns a call option for $55. Instead let’s focus on the fact that he sold a call option for $60. Because he agreed to sell those shares for $60, he must go out and purchase the stock for $65 and then sell it for $60, thus suffering a loss of $5 per share, or $500 for the entire option.
Now, let’s return to our $55 call option. The trader must still sell 100 shares for $60, but because he purchased a $55 call, he can exercise this option and, instead of paying the full market price of $65 per share, buy the shares for $55 and immediately sell them for $60. In this way, he has protected himself against an over-performing market. Further protection can be obtained by learning how to technically analyze stock charts, which can help you avoid betting on unreliable options.
Profits And Losses
As soon as the trader buys and sells the call options, he knows exactly how much he can make or lose. The loss is easy: it’s simply the difference between the call options: $60 – $20 = $40. It’s $40 because if the stock never fully appreciated (that is, never rose above $55), neither the trader nor the person he sold the option to would choose to exercise the option to buy; why would anyone buy a stock for $55 or $60 when the market price is $52?
The maximum profit is just as easily calculated. If the stock hits $60+, then the trader will use his option to purchase 100 shares for $55 each, and then sell those shares for $60, turning a profit of $5 per share, or $500 total. The original price for buying and selling the options ($40) must be deducted, to yield a maximum profit of $500 – $40 = $460.
Needless to say, the loss to profit margin (-$40 to +$460) is quite favorable. But before you put you rush into bull call spreads, I highly recommend some private coaching lessons from Jason Brown, founder of The Brown Report, which will help you trade like the pros.