With the S&P 500 still not moving much lower as many had predicted up to this point, an option trader still needs to consider some bullish strategies until the market does drop. Sentiment may push stocks lower at some point, but certainly there is no guarantee it will. Even if a pullback does happen sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.
When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching earlier this year. UnitedHealth Group Inc. (UNH) moved up and closed at $122 and formed a bullish base. With implied volatility (IV) generally being low at the time (which is advantageous for purchasing options as with a bull call spread) and a directional bias, a bull call spread can be considered.
The trader’s maximum profit on a bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one April 120 call (ITM) was purchased for 3.00 and one April 123 call (OTM) was sold for 1.00 resulting in a net debit of $2 (3 – 1). April expiration was about a month away. The difference in the strike prices is $3 (123 – 120). He would subtract $2 from $3 to end up with a maximum profit of $1 per contract. So if he traded 10 contracts, you could make $1,000 (10 X 100). He would need the stock to move a dollar or more higher ($123) by expiration to realize the maximum profit ($1).
Although he limited his upside profit potential, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to stay at its current price of $122 (the strike price of the purchased call (120) plus the net debit ($2)) at expiration. Effectively, the trader has created a theta (time decay) neutral position at the onset of the trade since he would break even if the stock never moved penny off of its current price of $122. The same could not be said of a long call position. A long call always has some type of negative theta meaning that for every day that passes, the option premium will get smaller due to the passing of time.
Advantage Versus Purchasing a Call
When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the in-the-money April 120 call, he would have paid $3. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option as well.
By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. In addition, buying an ITM debit spread like the bull call can offset time decay (theta). A long call or put position cannot be structured to offset theta completely. These are a couple of the advantages when comparing purchasing options outright to spreads. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the different strategies is a good way to limit potential losses.
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