Bull Call Spread - Strategies, Example, Advantages & Risks

In the derivatives market, traders who have a sound understanding of price movements can employ option trading strategies to earn profits. One such option trading strategy is the spread strategy, which is simple to implement but involves an option chain. 

A popular spread strategy is the bull call spread, which can be used when the market outlook on a stock or index is moderate and not aggressive, i.e., when the price of the stock or index value is expected to rise moderately. Let's explore how the strategy works and learn to implement it. 

What is a Bull Call Spread?

When you expect the price of a stock to rise moderately, a bull call spread option strategy would be effective. It involves buying one in-the-money (ITM) call option and selling an out-of-the-money (OTM) call option with a higher strike price for an underlying asset with the same expiration date. It is ideal for a market exhibiting an upward trend. 

How does a Bull Call Spread Strategy Work?

The core purpose of a bull call spread is to capture the difference in premium between the two options. If the underlying asset's price rises above the strike price of the bought call option, the profit from the long call will offset the loss from the short call. However, the profit is limited by the difference in strike prices.

In a bull call spread, the premium for the call purchase or long call option is higher than the premium for the call sold or short call option. So, this strategy starts with the debit in trading parlance, which is why it is a debit spread. 

To set up the bull call spread, you need to:

1. Buy one ATM call option
2. Sell one OTM call option

The key point to remember here is that all option contracts must belong to the same underlying asset and have the same expiry date. Also, the number of ATM and OTM call options should be the same. 

The calculations involved are:

• Net Premium Outlay = Premium paid for long call less premium received for short call
• Maximum loss = Net Premium Outlay + Commissions paid
• Maximum gain = Difference between strike prices of calls - (Net Premium Outlay + Commissions paid)
• Breakeven = Strike price of the long call + Net Premium Outlay

Example of Bull Call Spread

Let's assume you are bullish on the Nifty 50 Index and expect it to rise moderately over the next month. You implement a bull call spread to capitalise on this expected move while managing risk.

Current Market Situation: Nifty 50 Index is currently trading at 18,000

Strategy Setup:

• Buy Call Option (Lower Strike): Purchase a call option with a strike price of 18,000, expiring in one month
• Sell Call Option (Higher Strike): Sell a call option with a strike price of 18,500, expiring in one month

Premiums:

• The premium for the 18,000 call option is Rs 150
• The premium for the 18,500 call option is Rs 80

Net Premium Paid:

The net premium paid for the bull call spread is calculated as follows:

• Premium Paid (Lower Strike Call): Rs 150
• Premium Received (Higher Strike Call): Rs 80
• Net Premium Paid: Rs 150 – Rs 80 = Rs 70

Maximum Profit:

Difference between Strike Prices: 18,500 - 18,000 = 500

• Maximum Profit: Rs 500 – Rs 70 (Net Premium Paid) = Rs 430
• Maximum Loss: The maximum loss is the net premium paid for the spread, i.e., Rs 70
• Breakeven Point: The breakeven point is the lower strike price plus the net premium paid. 18,000 + Rs 70 = 18,070

If Nifty 50 Closes at 18,200

• The 18,000 call option is ITM by 200 points
• The 18,500 call option is OTM and expires worthless
• Profit = (18,200 - 18,000) - Net Premium Paid = 200 - 70 = Rs 130

If Nifty 50 Closes at 18,600,

• The 18,000 call option is ITM by 600 points
• The 18,500 call option is ITM by 100 points
• Profit = (18,500 - 18,000) - Net Premium Paid = 500 - 70 = Rs 430 (maximum profit)

Ideal Scenarios for a Bull Call Spread

Scenario 1: 

The bull call spread can be implemented in various scenarios. For example, consider a company that is expected to make announcements regarding its Q3 quarterly results. From the Q2 results, you expect the Q3 results of the current year to be better than the Q3 results of the previous year. The basis points by which the result will be better are unknown. 

You expect the market to react positively to the result announcement. So you think that the stock can go up but has unlimited upside.

Scenario 2: 

Consider that the stock you are tracking has experienced a downward trend for a while and has reached its lowest point in 52 weeks. It also tests the 200-day moving average and is near multi-year support. These technical aspects indicate that the stock could experience a relief rally. However, you cannot be completely bullish because the stock may still continue to trend downward. 

You have been following the stock consistently trading between the first standard deviation in both ways with mean-reverting behaviour. However, the stock price has declined suddenly and is now at the second deviation. When there is no fundamental reason for the decline, there is an excellent chance that the stock price could revert to near the second standard deviation. 

Technically, you can apply bull call spread in the following scenarios:

• To protect yourself on the downside
• When the amount of profit you can make is predefined
• The cost of market participation is lower due to the limited profit

Advantages and Risks of a Bull Call Spread

Some of the advantages of a bull call spread are:

• Limited risk capped by the net premium paid for the position. 
• Runaway losses can be avoided when the trader closes the long and short call positions at the right time.
• The strategy can be tailored to your risk profile. A conservative trader can choose a narrow spread to minimise the net premium outlay. An aggressive trader may go for a wider spread to maximise gains, but it means spending more on the position.
• It works out well if the bullish outlook of the market is realised.
• The maximum amount that can be lost using this strategy is also known at the beginning.

Similarly, the risks are:

• The entire premium paid for the call spread may be lost.
• Selling a call may result in an obligation to deliver if the security is assigned. The time difference between exercising the long call and settling a selling call may result in an assignment mismatch.
• The profit is capped regardless of how much the security rallies. 

Conclusion

The bull call spread is ideal for a bullish market outlook where you can take positions with limited risk and moderate upside. Generally, traders close the options positions to realise a profit or reduce losses instead of exercising the options and closing the positions because of the higher commission costs. Remember, you must quantify what a moderately bullish market is based on the volatility of the stock or the index.