Now that we’ve established the base characteristics of the long call, it’s time to up the complexity a notch. Today, we’re entering the realm of spread trades. The first and most logical progression after the long call is the bull call spread. It’s also known as a long call vertical.
The spread structure is simple. You buy a call option, but at the same time, you sell a higher strike call. The premium received reduces the overall trade cost while lowering your expiration breakeven price. And since the stock doesn’t have to move as much to profit, the bull call also carries a higher probability of profit versus a straight call purchase. Additionally, since we’re both buying and selling calls your delta, theta, and vega risk are all reduced. Indeed, that’s why we call the bull call a hedged trade.
Smart readers (i.e., all of you!) might well question whether there’s a trade-off for all these advantages. What, pray tell, are the cons to balance out these attractive looking pros? There are two. First, the short call limits your potential profit. That said, it may still be substantial, upwards of 100% or 150% if you structure the trade right. Second, the bull call spread accumulates profits slower than a long vanilla call.
Let’s take a quick look at an example using AAPL which made an appearance in this weekend’s Options Report. To fully grasp the benefits to the bull call spread, we’ll compare it to a long call. Suppose with the stock trading at $174 we went for the jugular by buying the Feb $175 call for $6.20. The relevant metrics are displayed below:
Long Feb $175 call @ $6.20
Max Risk: $6.20
Max Reward: Unlimited
Expiration Breakeven: $181.20
Greeks: 50 Delta, -5 Theta, 28 Vega
In contrast, suppose we enter a bull call spread by purchasing the Feb $175 call for $6.20 and selling the Feb $180 call for $4.10.
Long Feb $175/$180 bull call @ $2.10
Max Risk $2.10
Max Reward $2.90
Expiration Breakeven: $177.10
Greeks: 12 Delta, -1 Theta, 1 Vega
Can you see the benefits?
First, the max risk (and cost) fell from $6.20 to $2.10.
Second, the expiration breakeven fell from $181.20 to $177.10.
Third, the theta and vega were virtually neutralized while the delta fell dramatically from 50 to 12.
In exchange for this trio of benefits, all we gave up was the unlimited upside. But, come on! Having the potential to capture $290 on a $210 investment still amounts to a mouth-watering 138% return so don’t mistake “limited” for paltry.
Perhaps my favorite method for comparing two strategies is an overlay of their risk graphs. Check out the graphic below which shows the long call graph in blue and the bull call graph in orange. Can you see the potential pros and cons of the bull call spread?
How about this one?
Notice how much less risk the bull call has. Additionally, this spread delivers better returns (either fewer losses or greater gains) if AAPL ends up trading below $184. The only area where the long call trumps is above $184. Remember that! The only time a long call generates a higher return than the bull call (at least at expiration) is if the stock stages a powerful rally.
Now, here’s one more.
The green box illustrates the section where the bull call spread generates more reward than the long call. And then there’s the shift in breakeven prices. Notice how the profit zone kicks-in around $177.10 on the bull call, but not until $181.20 on the long call. That’s why the bull call spread has a higher probability of profit.
Throw it all together and seems the bull call spread deserves a spot in any directional traders playbook.
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