An option is a type of instrument whose value is determined by the underlying investment. In most cases, this underlying investment is stock (of a publicly traded company), but other types of investment vehicles can also be used instead. Stock options are nothing more than contracts between investors granting owners the right, but not the obligation, to buy or sell 100 shares of stock for a fixed price (strike price) by a given expiration date for a premium. Call options allow an investor to buy 100 shares of stock at the strike price, while Put options permit the sale of 100 shares of stock.
An investor holding call options may purchase 100 shares of stock at the fixed strike price – but is not obligated to do so. If the premium on the 100 shares is $4 per share, the maximum loss would be limited to $400, plus any commission fees charged for acquiring the option. If the market value of the stock rises above the strike price, the investor will net a profit. However, if the stock price falls or does not meet the strike price, the loss is limited to the premium paid, plus commission, because the investor is not obligated to buy the 100 shares of stock.
Investors value call options, because they can ‘lock-in’ a purchase price for a stock without having to actually buy it. For fast growing companies whose P/E ratio is very high, the investor’s risk is high, given the expectations the market has for that company. If things go well, stock prices may very well surge 40-50% in the next year. But,
if expectations are not met, then the price may plummet. A call option allows you to cash-in should things go well (by allowing you to buy stock at the strike price and sell it at a higher market price when the option is exercised), but limits losses to the premium amount, should the stock turn sour.
Some investors do not like the “all-or-nothing” approach to options. While the premium represents the maximum amount you can lose on an option, it is a set amount. Either the stock rises above the strike price and you make a profit, or it doesn’t and you lose the entire premium. One way to hedge against this possibility is to use a
stock option strategy known as the “bull spread.”
Options are generally used to hedge other investments, so those favoring the “bull spread” stock option investment strategy want to minimize their risk. This is why the “bull spread” option is one of most popular choices of investors. The “bull”refers to the fact that this strategy is used when investors are expecting stock prices to rise before
the expiration date – and rise higher than the historical norms for that stock.
When an investor uses the “bull spread” stock option investment strategy with calls, it means that two investments are being made simultaneously. The investor buys a call option with a lower strike price (strike price 1) while also writing a call option with a higher strike price (strike price 2). It is important to remember that the option class
and expiration date must be the same in this strategy. However, the premium or exchange price may be different for the two options. So what does this accomplish for the investor?
The “bull spread” (call) strategy works best when the investor thinks prices are going to rise, but not too much. He or she believes that prices will rise, but the overall amount is uncertain. The “bull spread” strategy limits profits since the maximum return is reached when the strike price 2 is reached, or exceeded, by the expiration date.
The maximum return will equal the difference between strike price 2 and strike price 1, minus the initial cost of the two options (premiums plus commission).
The big advantage in using the “bull spread” strategy for call options is that the maximum loss is limited to the initial debit. However, beware that both risk and profit are limited by this approach.