Exchange-traded funds (“ETFs”) have become a popular way for investors to reach every corner of the market, enabling them to achieve broad diversification by purchasing a single U.S.-traded security. Those looking to enhance their ETF trading may want to take a look at equity/stock option strategies to help control risks and/or leverage profits [see ETF Call And Put Options Explained].
In this article, we’ll take a look at how ETF investors can use the bull call spread strategy to profit from modest upside, while limiting maximum potential losses.
What Is a Bull Call Spread Strategy?
Suppose that you believe that the S&P 500 SPDR (SPY, A) will rally modestly over the coming month, but there’s an interest rate decision that could have a big negative impact. Purchasing the underlying stock would be risky, since the interest rate decision could lead to sharp losses, while purchasing outright call options may be an expensive position to establish [see also ETF Covered Call Options Strategy Explained].
The bull call spread represents an attractive alternative in this case, providing upside exposure with limited potential losses, by purchasing an in-the-money call option and selling an out-of-the-money call option. Since the short option covers some of the long option’s costs, the position can be established for cheaper than an outright call option.
Here’s what the option diagram looks like:
Who Is the Bull Call Spread Strategy Right For?
The bull call spread strategy is ideal for ETF investors that are moderately bullish, but would like to limit their maximum potential losses. Since the short call’s income offsets the long call’s costs, the strategy is also perfect for ETF investors that want to limit their upfront capital investment in the position, as a cheaper alternative to purchasing call options or buying stock on margin.
Since the options form a spread, the bull call spread works best in markets where investors are expecting only a modest move higher. The strategy is also ideal in markets where there may be a large downside risk, necessitating a way to limit maximum potential losses, as in the interest rate decision example that we explored in the first section [see also How To Hedge With ETFs].
What Are the Risks/Rewards?
The bull call spread strategy has a very well defined risk/reward profile, given that the options form a spread that’s neither net long nor short. For investors, the key breakeven point that they should consider before entering the position can be calculated by adding the strike price of the long call to the net premiums paid to establish the strategy [see 13 ETFs Every Options Trader Must Know].
The maximum profit and loss can be calculated as follows:
- Maximum profit is calculated by finding the difference between the strike prices of the two call options and then subtracting the net premiums paid and commissions.
- Maximum loss is simply the net premiums paid plus commissions.
How to Use a Bull Call Spread Strategy
Suppose that you decide to initiate a bull call spread on the S&P 500 SPDR , as mentioned in the scenario above. With SPY trading at 165.00, you decide to purchase one in-the-money 160 call for $6.50 and sell one out-of-the-money 170 call for $1.00, for a net debit of $550.00. The breakeven point is then 165.50 – or the long call plus net premiums paid.
Several different scenarios could play out from here:
|>170||$1,000 – $650 + $100 = $450|
|=165||$500 – $650 + $100 = -$50|
|<160||$0 – $650 + $100 = -$550|
- Bullish – SPY could rise past 170.00 and both options would be in-the-money, which means you’d realize $450.00 in profit – or $1,000.00 minus the net debit paid.
- Neutral – SPY could remain at 165.00 and only the short option would expire, which means you’d realize $50.00 in losses – or $500.00 minus the net debit paid.
- Bearish – SPY could fall below 160.00 and both options would expire worthless, which means you’d simply have to pay the $550.00 debit spread to enter the position.
The Bottom Line
The bull call spread strategy is ideal in moderately bullish scenarios, where investors would like to tightly control risk. Those looking for more bullish options may want to consider purchasing the underlying stock on margin or purchasing call options, although both of these strategies will involve higher costs to initiate the position than the bull call spread.
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Disclosure: No positions at time of writing.
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