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Options Strategies
"Bull Spread" Stock Option Investment Strategy
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
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 pershare, the maximum loss would be limited to $400, plus any commissionfees 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/Eratio 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 limitslosses 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 optionstrategy 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 historicalnorms 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.
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