Bull Spread

A bull spread is a widely used two-leg option trading strategy that involves buying and selling the option contracts of equal quantity of any financial asset having the same expiration but different strikes such that the strategy delivers positive P&L when the underlying has a bullish movement, hence its name.

When a trader uses the call option, it is called bull call spread; when they use the put option, it is referred to as bull put spread. The fundamental difference between these two types of bull spread strategy is the timing of the cash flow. However, both strategies allow the trader to collect a premium on expiration.

• A bull spread is a popular options trading strategy used by investors who expect a moderate increase in the price of an underlying asset.
• It involves simultaneously buying and selling call options with different strike prices but the same expiration date.
• The strategy aims to limit the investor's downside risk while allowing for potential profits if the underlying asset price rises.
• Bull spreads can be constructed using various strike prices combinations, such as vertical spreads

Bull spread is an options strategy that is used by traders when they think the price of the underlying asset will increase conservatively or moderately. This strategy involves buying and selling of the securities or underlying assets with the same expiration date. However, the strike prices are different.

The two types of bull spread options are bull call spread and bull put spread. For a bull call spread, a trader pays the premium upfront and can collect profits after the expiration date. In the case of a bull put spread, the premium is paid upfront to the trader, and the trader must try and retain as much of the premium as possible till the expiration date.

It is important to note that both these strategies allow the traders to collect the premiums on the sale of their options. Therefore, the initial investment of this deal is lesser than that of just purchasing the options.

This strategy allows the trader to experience maximum profits when the underlying asset closes at a price that is equal to or higher than the higher strike price set by them.

There are primarily two types which depend on if Calls are used, or Puts are used to implement the strategy. Let us understand how traders use the bull spread strategy by understanding its types from the discussion below.

#1 - Bull Call Spread

This strategy is deployed by buying ATM (at the money) call options while selling an equal number of OTM (out of the money) call options of the same underlying and same expiry. While deploying this strategy, a net debit of the Premium will occur, or a cost will be involved in setting up this strategy.

Bull Call Spread Formula (Where: X1<X2, denotes the strike price)

• Net Premium (Debit) = Premium Debit while buying CALL (of Strike X1) – Premium Credit while Selling CALL (of Strike X2).
• Max Loss = Net Premium Debit.
• Max Profit = (X2-X1) – Net Premium Debit.

#2 - Bull Put Spread

This strategy is deployed by selling ATM (at the money) put options while buying an equal number of OTM (out of the money) put options of the same underlying and same expiry. While deploying this strategy, a net credit of the Premium will occur, or payment will be received on setting up this strategy.

Bull Put Spread Formula (Where: X1<X2, denote the strike price)

(Where X1< X2, denoting the strikes)

• Net Premium (Credit) = Premium Received while selling PUT (of Strike X2) – Premium Debit while buying PUT (of Strike X2).
• Max Loss = (X2-X1) – Net Premium Credit.
• Max Profit = Net Premium Credit.

Let us understand the concept of bull spread strategies with the help of a couple of examples. These examples will help us understand the intricacies of the concept.

Example #1

Let us take a listed company ABC whose stock is trading at $100 currently.

• Following are the Strike Prices and LTP (last trading price) of the ATM and OTM Call options
• Strike Price = $100 | LTP = $5 (ATM)
• Strike Price = $110 | LTP = $4 (OTM)
• Following are the Strike Prices and LTP (last trading price) of the ATM and OTM Put options
• Strike Price = $100 | LTP = $4 (ATM)
• Strike Price = $90 | LTP = $3 (OTM)

Solution:

Bull Call Spread:

From the given information we can create a "Bull Call Spread” description=”A bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.” url=”https://www.wallstreetmojo.com/bull-call-spread/”]Bull Call Spread as following:

#1 - Net Premium (Debit) = Buy Call of Strike $100 & Sell Call of Strike $110

• Net Premium (Debit) = -$5 +$4 (Positive sign denoted inflow and Negative indicates outflow)
• Net Premium (Debit) = -$1 (As this is negative quantity this is net outflow or debit)

#2 - Bull Call Spread Max Loss = Net Premium Debit

• Max Loss = $1

#3 - Bull Call Spread Max Profit = (X2-X1)-Net Premium Debit

• Max Profit = ($110-$100) - $1 = $9

Bull Put Spread:

From the given information we can create a Bull Put Spread as following:

#1 - Net Premium (Credit) = Sell Put of Strike $100 & Buy Put of Strike $90

• Net Premium (Credit)  = +$4 -$3 (Positive sign denoted inflow and Negative indicates outflow)
• Net Premium (Credit)  = +$1 (As this is positive quantity this is net inflow or credit)

#2 - Max Loss = (X2-X1) – Net Premium Credit

• Max Loss = ($100-$90) - $1 = $9

#3 - Max Profit = Net Premium Credit

• Profit = $1

Example #2

Let us take an example of Amazon.com Inc. stock and try to build a Call Spread & Put Spread strategy and also analyze the Profit and Loss from the payoff chart

#1 - Bull Call Spread on Amazon.com Inc.

At the end of the trading session on 25th October 2019, the following was the stock price of Amazon.com.

The option chain of Apple for options contracts expiring on 1^st November is shown below.

The necessary data is now available for building this strategy.

We would deploy a Bull Call Spread on Amazon.com Inc. stock just a few minutes before the close of the market on 25th October 2019

The two strikes chosen are $1760 and $1763. The Calls of each of these strikes have been highlighted. In this case, a $1760 strike Call (ATM) will be bought, and the same quantity of $1763 strike Call (OTM) will be sold.

The prices highlighted on the option chain will be used to build the payoff chart of the strategy.

When the premiums of each of these strikes were fed in the option strategy builder, the following result was obtained. It can be seen that the strategy has a net debt of $0.95.

Source: optioncreator.com

Source: optioncreator.com

The following points are the highlights of Amazon.com Inc. stock when held till expiry:

• Bull Call spread Max Loss is equal to the Net Premium paid at the time of deployment = $0.95
• Bull Call Max profit = (1763-1760) – $0.95 = $3-$0.95 = $2.05
• The profit increases linearly as the stock price moves from $1760 to $1763, which are the two strikes chosen for this strategy.
• Break Even point = $1760 (Lower Strike) + $0.95 (Net Premium Paid) = $1760.95
• Below $1760 & above $1763 both the loss and gain are capped to $0.95 & $2.05 respectively.
• The risk-reward ratio is 2.05/0.95 = 2.16

#2 -Bull Put Spread on Amazon.com Inc.

We would now deploy a Bull Put Spread on Amazon.com Inc. stock just a few minutes before the close of the market on 25^th October 2019.

The two strikes chosen are $1758 and $1763. The Puts of each of these strikes have been highlighted. In this case, a $1763 strike Put (ATM) will be sold, and the same quantity of $1758 strike Call (OTM) will be bought.

The prices highlighted on the option chain will be used to build the payoff chart of the strategy.

When the premiums of each of these strikes were fed in the option strategy builder, the following result was obtained. It can be seen that the strategy has a net credit of $3.76.

Source: optioncreator.com

The following points are the highlights of Amazon.com Inc. stock when held till expiry:

• Bull Call spread Max gain is equal to the Net Premium paid at the time of deployment = $3.76.

• Bull Call Max loss = $3.76 – (1763-1758) = $3.76-$5= -$1.24.
• The profit increases linearly as the stock price moves from $1758 to $1763, which are the two strikes chosen for this strategy.
• Break Even point = $1763 (Higher Strike) – $3.76 (Net Premium Paid) = $1759.24
• Below $1758 & above $1763 both the loss and gain are capped to $1.24 & $3.76 respectively.
• The risk-reward ratio is 3.76/1.24 = 3.03

Let us understand the advantages of adopting the this strategy through the discussion below.

• Being a spread strategy, it is hedged and limits the loss to a certain pre-defined quantity, which can be calculated before the strategy is entered. (This phenomenon was observed in both the above example of deploying Bull Call and Bull Put Spread on Amazon.com Inc. stock)
• Return on capital is blocked as the margin is higher compared to naked option selling. (as being spread strategy lesser margin is blocked)
• Both Net Credit and Net Debit alternatives are available for Bull Spreads.

Despite the advantages, there are a few factors of the bull spread options that prove to be a hassle for traders. Let us understand the disadvantages through the explanation below.

• The maximum profit is limited in either Bull Call or Bull Put Spreads.
• The risk-reward ratio is skewed in favor of risk.

This has been a guide to What is a Bull Spread and its definition. We explain its examples, types, advantages, and disadvantages in detail. You can learn more from the following articles –

• Box Spread
• Bear Spread
• Options Spread
• Bear Put Spread