There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying asset at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
Let's look at the bull call spread.
The basic setupThe way that you construct a bull call spread is to buy a lower strike price call, and then sell a higher strike price call. The goal is to have the stock rise in price and close upon expiration at a price greater than or equal to the higher strike. A vertical spread will have two strike prices with the same expiration month. Since the call contract with the higher strike price will be worth less than the call contract with the lower strike price, the net result of this transaction will be a net debit.
As an example, let's say that a stock is currently trading at $50. A $60 call is priced at $4, and a $70 call is priced at $1. Buying the $60 call while simultaneously selling the $70 call would result in a net debit of $3. Let's work through the position's maximum loss, maximum gain, and breakeven point.
Max loss: net debitThe most that you can lose on any debit spread like a bull call spread is simply the amount that you paid for it -- the net debit. The max loss occurs if the stock closes upon expiration at any point less than the lower strike price. All contracts would expire completely worthless with zero value.
In this example, the max loss would be $3, which would occur if the stock closed upon expiration below $60.
Max gain: Difference in strike prices minus net debitThe most that you can make on a bull call spread is the difference in strike prices less the amount paid. Since a bull call spread has a predefined difference between the strike prices, the max gain occurs if the stock closes upon expiration at any point greater than or equal to the higher strike price. If that occurs, then technically you exercise the call to purchase the stock at the lower strike, while the other call is automatically exercised if it's in the money and you would sell the stock at the higher strike. But then you must subtract the upfront cost of the trade.
In this example, the max gain would be $7, which would occur if the stock closed upon expiration greater than or equal to $70. You would purchase the stock at $60, sell it at $70, but subtract out the $3 in premium that you paid.
Breakeven: lower strike plus net debitIn order to breakeven on this trade, the stock must close upon expiration at a price equal to the lower strike plus the net debit of the trade. The lower strike call must be in the money upon expiration in order for the lower strike call to have any value, but you would need to recoup the upfront cost in order to breakeven. The lower strike call's value would be equal to the net debit, while the higher strike call expires worthless.
In this example, the breakeven would be $63. The $60 call would be worth exactly $3, equal to the initial premium paid, while the $70 call would expire worthless.
No margin requirementsWhile some options positions have margin requirements associated with them, debit spreads generally do not. That's because your risk is very clearly defined as the upfront cost. The worst thing that can happen is that all contracts expire worthless. Neither you nor your broker/dealer is exposed to potential losses beyond this amount. This makes the position simpler to manage and monitor, since you don't need to worry as much about margin calls or other margin equity requirements.
The article What Is a Bull Call Spread? originally appeared on Fool.com.
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