Saturday, November 2, 2013

Bull Call Spreads or Debit Spreads

The terms bull and call imply a bias toward an upward price direction, so you can assume this strategy involves a spread that goes long the market by using calls. Debit implies that you are paying for the trade and that the costs are being debited from your account. Other courses or books may refer to this as a vertical bull call spread
.What is usually involved in this strategy is the purchase of a close-to-the-
money or an in-the-money call and at the same time the sale of a further
away strike price call option of the same expiration date. The close-to- or
in-the-money call option may cost a great deal of money as it is near or
lower to where the underlying futures contract price is trading, especially
if there is substantial time remaining until the option’s expiration. Traders
spread this cost off by selling or writing a further out-of-the-money call op-
tion. When you sell or write a call, you collect premium or receive a credit
to your account. This credit reduces the cost of the close-to- or in-the-
money call option.
The profit/loss profile for this strategy is a limited risk and a lower ex-
pense for the investor as premium costs are reduced by the sale of the
higher strike price call. The short call is covered by the long call so there is
a predetermined risk factored in this trade and no unnecessary risks asso-
ciated with option writing. The profit potential is limited to the level between
the two strike prices minus the premium costs, the commission, and fees.
For example, if March silver futures were trading at $4.10 on November
28 and you expected the market price to rise to at least $4.75 by January,
then you might look at buying a March 425 call and at the same time selling
the March 475 call. The strike price difference is 50 cents. If each penny
move in silver futures equals $50, then this is a $2,500 maximum spread dif-
ference. If the cost of doing this trade is, say, a net of $500 for the premium,
$65 per option (times two) for commissions, and $5 per option for fees, then
your total cost is $640. That is your risk and maximum loss amount. Your
maximum profit is $2,500 – $640, or $1,860.

Your risk/reward ratio is almost 1 to 3 in this scenario. If silver settlesbelow $4.25 at expiration, then you would lose $640. If silver does move andsettles above $4.75 at expiration, then your net profit is $1,860. If silver re-ally took off to $10 per ounce, you are still limited to the $1,860 profit.Because this is a spread, you can leg into or out of a position. If, on theone hand, the silver market fell to, say, $3.50 first, both the 425 and the 475calls would decline in value. If it is financially beneficial and if there is agood amount of time remaining, then you may consider buying back theshort 475 call and staying long the 425 call, provided that you have enoughfree equity in your account to pay the difference of the 425 call. If this ispossible, then you are now in an unlimited profit potential situation and arenot locked into a defined profit situation. If, on the other hand, the marketexploded up to $4.75 first and you sold the 425 call, that would leave younet short a 475 call with unlimited risk and you would be subject to a mar-gin requirement. Most traders buy the spread and liquidate the spread, butthe opportunity to leg out of a spread does exist.




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