Bull Spread

Bull Spread

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Source: Bull Spread (wallstreetmojo.com)

What is 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.

Types of Bull Spread

There are primarily two types which depend on if Calls are used, or Puts are used to implement the strategy

#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 moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more) 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 SpreadBull Call SpreadA 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.read more Formula (Where: X1<X2, denotes the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more)

  • 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.

Example of Bull Spread

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 SpreadBull Call SpreadA 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.read more” 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[/wsm-tooltip] 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 SpreadBull Put SpreadA 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.read more 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

Practical Application Based Example

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

Practical Application Based Example 1

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

Bull Spread Example 1.1
Practical Application Based Example 1.2

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.

Bull Spread Example 1.3
Example 1.4

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.

Bull Spread Example 1.5

Source: optioncreator.com

Practical Application Based Example 1.6
Bull Spread Example 1.7

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.
  • Breakeven 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 25th 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 use to build the payoff chart of the strategy.

Practical Application Based Example 1.8
Bull Spread Example 1.9

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.

Practical Application Based Example 1.10
Bull Spread Example 1.11
Practical Application Based Example 1.12

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.
  • Breakeven 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

Advantages

  • 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 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.

Disadvantages

Recommended Articles

This has been a guide to What is Bull Spread and its definition. Here we discuss the formula to calculate bull spread (call and put) along with examples and types. You can learn more from the following articles –