A bull spread is an options strategy that seeks to capitalize on a rise in a stock’s price. A bull spread is different from buying only a call option because the strategy sells another call option in order to lower the total cost of entering the position. However, this means that the bull spread has a limited upside as well as a limited downside.
A bull spread is ideal for sophisticated investors who want to bet on a very specific appreciation of a company’s stock. To get the bull spread right, the investor must not only hold the view that a stock should appreciate, but also have a price in mind that he or she expects the stock to appreciate to, as well as an idea of the time frame in which it will reach that price. If the investor gets these aspects wrong, then the position may either lose money or not be as profitable as it could have been.
Despite its downsides, a bull spread is often used because it is less costly to enter into compared with buying a naked call. This means that the investor can enter into a greater number of options contracts than he or she could otherwise, given the same pool of funds. This gives the investor greater leverage in the position, meaning that profits can be larger if he or she is correct. Alternatively, the extra funds can be used to fund other positions, giving the investor greater diversification.
To construct a bull spread, an investor buys a call option at one strike price and simultaneously sells a call option with a higher strike price. Since a higher strike price call option will always sell for less than one with a lower strike price, this results in a net outlay to the investor. However, since the investor receives the proceeds from selling the higher strike call, the net cost of the position is lower.
The result of this bull spread is that the investor has a range of underlying stock prices less than the owned call’s strike price where the investor loses his net outlay for the position. Then the investor makes increasing amounts of money when the strike price is higher than the owned call, but lower than the sold call. Finally, when the strike price is higher than the sold call, the investor’s profits are capped, since any increase in the value of the owned call is offset one-for-one by the amount the investor owes for the sold call.