Bull Call Spread An Alternative to the Covered Call

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Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative bull call spread strategy requires the investor to buy deep-in-the-money call options instead.

Since the objective of writing covered calls is to earn premiums, it makes sense to sell near-month options as time decay is at its greatest for these options. Hence, the two strategies that we are comparing will involve selling near-month slightly out-of-the-money call options.

Example

Suppose we have a stock XYZ currently trading at $50 in June and the JUL 55 call is priced at $2 while a JUL 45 call is priced at $5.50.

Investor A enters a bull call spread by buying the JUL 45 call while selling the JUL 55 call. His upfront investment is $550 (long call) – $200 (short call) = $350.

Investor B does a covered write by buying 100 shares of XYZ at $50 each and selling a JUL 55 call. His upfront investment is $5000 (long stock) – $200 (short call) = $4800.

The table below shows their profit/loss at various stock price on expiration date.

Strategy Upfront Investment Stock Price on Expiration Date
Below $45 $45 $50 $55 & Above
Bull Call Spread $350 -$350 -$350 +$150 +$650
Covered Call $4800 Unlimited -$300 +$200 +$700

As can be seen, the maximum potential profit for the bull call spread is only slightly lesser than the covered call but the covered call has a potentially unlimited downside risk (all the way up to $4800 in potential losses).

Hence, the bull call spread is clearly a superior strategy to the covered call if the investor is willing to sacrifice some profits in return for higher leverage and significantly greater downside protection.

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Bull Call Spread: An Alternative to the Covered Call

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Bull Call Spread

The bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.

Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month.

Bull Call Spread Construction
Buy 1 ITM Call
Sell 1 OTM Call

By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. The bull call spread option strategy is also known as the bull call debit spread as a debit is taken upon entering the trade.

Limited Upside profits

Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial debit taken to enter the position.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Downside risk

The bull call spread strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the spread position.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the bull call spread position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Long Call + Net Premium Paid

Bull Call Spread Example

An options trader believes that XYZ stock trading at $42 is going to rally soon and enters a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.

The stock price of XYZ begins to rise and closes at $46 on expiration date. Both options expire in-the-money with the JUL 40 call having an intrinsic value of $600 and the JUL 45 call having an intrinsic value of $100. This means that the spread is now worth $500 at expiration. Since the trader had a debit of $200 when he bought the spread, his net profit is $300.

If the price of XYZ had declined to $38 instead, both options expire worthless. The trader will lose his entire investment of $200, which is also his maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the bull call spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.

Long Call Spread

AKA Bull Call Spread; Vertical Spread

The Strategy

A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned.

This strategy is an alternative to buying a long call. Selling a cheaper call with higher-strike B helps to offset the cost of the call you buy at strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.

Options Guy’s Tips

Because you’re both buying and selling a call, the potential effect of a decrease in implied volatility will be somewhat neutralized.

The maximum value of a long call spread is usually achieved when it’s close to expiration. If you choose to close your position prior to expiration, you’ll want as little time value as possible remaining on the call you sold. You may wish to consider buying a shorter-term long call spread, e.g. 30-45 days from expiration.

The Setup

  • Buy a call, strike price A
  • Sell a call, strike price B
  • Generally, the stock will be at or above strike A and below strike B

NOTE: Both options have the same expiration month.

Who Should Run It

Veterans and higher

When to Run It

You’re bullish, but you have an upside target.

Break-even at Expiration

Strike A plus net debit paid.

The Sweet Spot

You want the stock to be at or above strike B at expiration, but not so far that you’re disappointed you didn’t simply buy a call on the underlying stock. But look on the bright side if that does happen — you played it smart and made a profit, and that’s always a good thing.

Maximum Potential Profit

Potential profit is limited to the difference between strike A and strike B minus the net debit paid.

Maximum Potential Loss

Risk is limited to the net debit paid.

Ally Invest Margin Requirement

After the trade is paid for, no additional margin is required.

As Time Goes By

For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you purchased (bad) and the option you sold (good).

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.

If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the option you bought faster than the out-of-the-money option you sold, thereby increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Technical Analysis Tool to look for bullish indicators.

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An Alternative Covered Call Options Trading Strategy

Books about option trading have always presented the popular strategy known as the covered-call write as standard fare. But there is another version of the covered-call write that you may not know about. It involves writing (selling) in-the-money covered calls, and it offers traders two major advantages: much greater downside protection and a much larger potential profit range. Read on to find out how this strategy works.

TUTORIAL: Option Spread Strategies

Traditional Covered-Call Write
Let’s look at an example using Rambus (RMBS), a company that manufactures and licenses chip interface technologies. We can begin by looking at the prices of May call options for RMBS, which were taken after the close of trading on April 21, 2006. RMBS closed that day at 38.60, and there were 27 days left in the May options cycle (calendar days to expiration). Option premiums were higher than normal due to uncertainty surrounding legal issues and a recent earnings announcement. If we were going to do a traditional covered-call write on RMBS, we would buy 100 shares of the stock and pay $3,860, and then sell an at-the-money or out-of-the-money call option. The short call is covered by the long stock (100 shares is the required number of shares when one call is exercised). (To learn more about covered-call strategies, read Covered Call Strategies For A Falling Market.)

At the time these prices were taken, RMBS was one of the best available stocks to write calls against, based on a screen for covered calls done after the close of trading. As you can see in Figure 1, it would be possible to sell a May 55 call for $2.45 ($245) against 100 shares of stock. This traditional write has upside profit potential up to the strike price, plus the premium collected by selling the option.

Figure 1 – RMBS May option prices with the May 25 in-the-money call option and downside protection highlighted.

The maximum return potential at the strike by expiration is 52.1%. But there is very little downside protection, and a strategy constructed this way really operates more like a long stock position than a premium collection strategy. Downside protection from the sold call offers only 6% of cushion, after which the stock position can experience un-hedged losses from further declines. Clearly, the risk/reward seems misplaced.

Alternative Covered Call Construction
As you can see in Figure 1, we could move into the money for options to sell, if we can find time premium on the deep in-the-money options. Looking at the May 25 strike, which is in-the-money by $13.60 (intrinsic value), we see that there is some decent time premium available for selling. The May 25 call has $1.20 ($120) in time premium (bid price premium) value. In other words, if we sold the May 25, we would collect $120 in time premium (our maximum potential profit). (Find out about another approach to trading covered call. Read Trade The Covered Call – Without The Stock.)

Looking at another example, a May 30 in-the-money call would yield a higher potential profit than the May 25. On that strike, there is $260 in time premium available.

As you can see in Figure 1, the most attractive feature of the writing approach is the downside protection of 38% (for the May 25 write). The stock can fall 38% and still not have a loss, and there is no risk on the upside. Therefore, we have a very wide potential profit zone extended to as low as 23.80 ($14.80 below the stock price). Any upside move produces a profit.

While there is less potential profit with this approach compared to the example of a traditional out-of-the-money call write given above, an in-the-money call write does offer a near delta neutral, pure time premium collection approach due to the high delta value on the in-the-money call option (very close to 100). While there is no room to profit from the movement of the stock, it is possible to profit regardless of the direction of the stock, since it is only decay-of-time premium that is the source of potential profit.

Also, the potential rate of return is higher than it might appear at first blush. This is because the cost basis is much lower due to the collection of $1,480 in option premium with the sale of the May 25 in-the-money call option.

Potential Return on in-the-Money Call Writes
As you can see in Figure 2, with the May 25 in-the-money call write, the potential return on this strategy is +5% (maximum). This is calculated based on taking the premium received ($120) and dividing it by the cost basis ($2,380), which yields +5%. That may not sound like much, but recall that this is for a period of just 27 days. If used with margin to open a position of this type, returns have the potential to be much higher, but of course with additional risk. If we were to annualize this strategy and do in-the-money call writes regularly on stocks screened from the total population of potential covered-call writes, the potential return comes in at +69%. If you can live with less downside risk and you sold the May 30 call instead, the potential return rises to +9.5% (or +131% annualized) – or higher if executed with a margined account.

Figure 2 – RMBS May 25 in-the-money call write profit/loss.

The Bottom Line
Covered-call writing has become a very popular strategy among option traders, but an alternative construction of this premium collection strategy exists in the form of an in-the-money covered write, which is possible when you find stocks with high implied volatility in their option prices. This was the case with our Rambus example. These conditions appear occasionally in the option markets, and finding them systematically requires screening. When found, an in-the-money covered-call write provides an excellent, delta neutral, time premium collection approach – one that offers greater downside protection and, therefore, wider potential profit zone, than the traditional at- or out-of-the-money covered writes.

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