A bull call spread involves buying a call option and selling a call option with a higher exercise price on the same asset. It limits risk and allows for profit if the stock price rises moderately. The maximum potential loss is the difference between premiums paid and received, and the break-even point is determined by dividing costs by 100 and adding to the lower strike price. The strategy is best used for small, predictable market increases.
A bull call spread is an investment strategy that involves two call options on the same asset with the same expiration date. In this approach, an investor buys a call option to buy shares of a security in the near future for an exercise price at or near the current price of the underlying asset and sells a call option with an exercise price moderately above the current price. An investor uses a bullish spread call when he believes a stock price will rise in the near future, but only moderately. The bull call spread allows the investor to benefit from the price growth but also to limit the risk of the investment. When using this strategy, an investor can anticipate his maximum potential loss, his breakeven point and his maximum profit.
For example, Warbucks Coffee is currently trading at $20 US Dollars (USD) per share. An investor, anticipating a rise in the stock price of Warbucks Coffee in the coming month, buys a call option for 100 shares at a strike price of $20 USD with expiration in one month for a payment of $300 USD. It also sells a call option for 100 shares at a $25 USD strike price with expiration in one month for a $100 USD premium. In the following month, Warbucks Coffee climbs to $24 USD per share. The bullish call spread results in a profit of $200 USD for the investor, which is calculated by multiplying 100 shares by the $4 USD price increase minus the $300 USD payment for the first option plus the $300 premium. 100 received for the second option.
The maximum potential loss with a bullish call spread is the discrepancy between the premiums paid and received by the investor for the two call options. If the stock price does not rise as expected, the options are worthless at expiration and the investor loses what he paid for the options. The break-even point for a bullish call spread is determined by dividing costs by 100 and then adding the obtained value to the lower strike price. In the example given, the break-even point occurs when the stock price has increased to $22 USD per share. With this strategy, the investor makes a profit if the stock price moves between $22 USD and $25 USD.
If the stock price rises to above $25 USD per share, the bullish call spread limits your profit potential. The second call option, while limiting the downside risk, also limits the maximum profit. If the price rises to $30 per share, the investor earns $10 per share with the first option and loses $5 per share with the second option. While he would still make a $300 profit on the deal, he lost $500 USD by having the second call option. For this reason, the bullish spread call only makes sense when the market‘s expected increase is small and the upper limit of this increase is quite predictable.
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