Bull Call Spreads

Bull Call spreads are a popular way to option spread. This spread allows for limited risk, limited reward and a cost basis that is typically much lower than buying options outright. When compared to buying an at-the-money call the Bull Call spread looks more attractive.

To establish a bull call position buy a call of a lower strike and sell a call of a higher strike. Normally the buy is close to the underlying price. Buying close to the underlying price drops your entry cost substantially when compared to a straight option purchase You can however buy the spread further out of the money to lower trade costs.

Example
Dec '04 Wheat futures	319
Dec '04 Wheat 320 call	14 1/2
Dec '04 Wheat 340 call	8 1/2

Buy the 320 call and sell the 340 call to establish the Bull Call spread

Long Dec '04 Wheat 320 call	14 1/2	$725
Short Dec '04 Wheat 340 call	8 1/2	$425
Net Cost:	6 points	$300

The position cannot lose more than the initial cost of the spread plus trade fees and the maximum upside is the difference between the two strike prices plus any trade costs associated with the transaction.

Maximum profit =	differences between the two strike prices minus trade fees
Maximum profit =	(340 - 320) - trade fees
Maximum profit =	20 points - trade fees
Maximum profit =	$1,000 - $70
(Assume $35 per option for all trade fees and commissions. Wheat is $50.00 per point.)
Maximum profit =	$970

Risk Profile
The risk for Bull Call Spreads is the amount of premium paid for the spread plus all trade fees associated with the trade. All of your investment is at risk until the market moves above the strike price of the long option in your spread. At exercise if the market is trading below the long option strike price then your spread is worthless and you loose 100% of your investment. A 320 / 340 Wheat Bull Call spread is worthless on expiration day if the price of Wheat is below 320. Above the strike price the long option the spread makes 100% of the move of the underlying issue at expiration until the short option's strike price. For instance a 320 / 340 Wheat Bull Call spread makes money at expiration above 320 until the market reaches 340. Profits are limited to the short option's strike price. A Wheat 320 / 340 Bull Call spread is worth 10 points on expiration if the market is trading at 330. The same spread will be worth 20 points at market price of 340, and for all values above 340 on expiration day.

Maximum Risk =	cost of initial trade plus trade fees
Maximum Risk =	$300 + $70
(Assume $35 per option for all trade fees and commissions. Wheat is $50.00 per point.)
Maximum Risk =	$370

Breakeven analysis
Bull Call spreads provide a more favorable risk reward than buying an option alone. Your breakeven point is where the market moves beyond the time value on the option. Time value is option premium minus intrinsic value.

In our December Wheat example the 320 calls are out of the money, therefore the entire option premium is time value. In order to re-coup the cost of the option the market needs to move above 335 ½. (Option strike plus time value)

Buying a call alone

Breakeven =	(strike price + time value) + trade fees
Breakeven =	(320 + 14 ½) + trade fees
Breakeven =	334 ½ + 1 point
(Assume 1 point per option for all trade fees and commissions.)
Breakeven =	335 ½

The breakeven for a Bull Call spread is calculated the same way. In our example the cost of the spread is 6 points.

Bull Call spread

Breakeven =	(strike price of purchased call + time value) + trade fees
Breakeven =	(320 + 6) + trade fees
Breakeven =	326 + 2 points
(Assume 1 point per option for all trade fees and commissions. Two options were used.)
Breakeven =	328

Risk of Exercise
If a purchased call option is in the money (the market price is above the strike price) then your option can be automatically exercised by the exchange. At exercise the option holder will receive a long futures contract at the strike price of your option. A March 230 Corn call would exercise into a long March Corn future at 230 if the price of March Corn is above 230 on expiration day. One important note, when your option is exercised you will need to have sufficient funds in your account for the margin requirement.

In the case of Bull Call spreads it is possible to for the market to be above the price of the purchased call but below the short option at exercise. In our Wheat example, assume that at expiration Wheat futures are trading at 330. The long call option at 320 would be exercised into a long futures contract at 320 giving you a profit of 10 points. The short call option at 340 would expire worthless. You would be left with a long Wheat futures position from 320.

Assume at expiration Wheat futures are trading at 380 - well above the higher strike price of the Bull Call spread. The long call option at 320 would be exercised into a long futures contract at 320. The short call option at 340 would be exercised into a short futures position at 340. The short futures at 340 would offset against a long futures contract at 320 resulting in a 40 point profit - minus any trade fees.

Option Values Before Expiration
At expiration options are worth 100% of intrinsic value. Prior to expiration options can be worth more or less than their intrinsic value. Various market forces act on option prices prior to option expiration. Some of these forces are time before expiration, market volatility and interest rates. For example an important government report could cause a market to drop tremendously. Put option values for this market could jump considerably in response to the news announcement.

Uses for Bull Call Spreads
A Bull Call spread is useful in any market, stock or futures. You can use the Bull Call spread to establish a larger position in a market. If the market moves in your direction you can exit the Bull Call spread with a profit and roll to higher strike prices. In the Wheat example, if the market moves to 340 you could exit the 320/340 spread and establish a new position at 340/360 or even 350/370.