Bull Spreads

A bull spread provides the greatest profit potential when the underlying stock's market value rises. With the bull spread, you buy an option with a lower striking price and sell another with a higher striking price. You can employ either puts or calls in the bull spread.

This example describes the ideal situation, in which both sides of the spread are profitable, because the stock's price behaves perfectly to suit the spread. Of course, you have no control over price movement, so this outcome will not always occur.

Even when only one side is profitable, however, the strategy works as long as you achieve an overall net profit.

[caption id="attachment_12545" align="aligncenter" width="470"]Example of bull spread. Example of bull spread.[/caption]


Bull Spread, Not a Bad Thing: You open a bull spread using calls. You sell one December 55 call and buy one December 50 call, as shown in Figure above. At the time of this transaction, the underlying stock's market value is $49 per share. After you open the spread, the stock's market value rises to $54 per share. When that occurs, the 50 call increases in value point for point once it is in the money. The short 55 call does not change in value as it remains out of the money and, in fact, will drop in value as its time until expiration nears. Because of the advantage the spread creates at the time the stock has reached the $54 per share level, both sides of the spread will be profitable. The long 50 call rises in value and the short 55 call remains out of the money.

Smart Investor Tip

The spread is most profitable when the stock's price changes in the desired direction, timing, and pattern. Both sides of the spread can work out well. This would be much easier if stock price movement could be controlled or predicted -- which it cannot.

A bull vertical spread is profitable when the underlying stock's price moves in the anticipated direction. For example, a lower-priced call will be profitable if the stock rises in value, whereas the higher-priced short call will not be exercised as long as it remains out of the money, as previously illustrated.

A bull vertical spread with defined profit and loss zones is shown in Figure below.

[caption id="attachment_12546" align="aligncenter" width="300"]Bull vertical spread profit and loss zones. Bull vertical spread profit and loss zones.[/caption]


Defining the Zones: You sell one September 45 call for 2, and buy one September 40 call for 5. The net cost is $300. When the stock rises between $40 and $45 per share, the September 40 call rises dollar for dollar with the stock, while the short September 45 call remains out of the money. Its premium value will decline as time value disappears. As long as the stock remains within this five-point range, both sides can be closed at a profit (as long as closing the positions would produce net income higher than your initial cost of $300). If the stock's price rises above $45 per share, the five-point spread in striking prices will be offset by the long and short positions. Both calls will be in the money. So this strategy limits both profits as well as losses.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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