Taking into account the inherent volatility of the stock market, traders have been looking for ways to offset the risk of price fluctuations that have a negative impact on them. In the field of options, one way to deal with this risk is to adopt a bull market spread option strategy, such as a bull market call spread option strategy.
This strategy involves the purchase of call options, which gives you the right to buy a certain stock at a defined strike price and simultaneously sell call options on the same stock with the same expiration date but different strike prices. The strike price of the call option you sold is higher than the strike price of the call option you bought. This is essentially a way to hold a long position while paying part of the cost.
A similar strategy involves a bull market put spread option strategy, which involves selling a put option on one stock and then buying another put option with the same expiration date with a lower exercise price on the same stock. These types of strategies can help traders hedge positions when they are moderately bullish. Let us take the bull market call spread option strategy as an example to see how the bull market spread option strategy works.
Which vertical option spread should you use?
Bull market call spread option strategy
You expect the stock price to rise moderately in the near future and want to take advantage of this trend. Specifically, you expect the stock of ABC Corporation (currently trading at $50) to rise to approximately $55 in the next few months. This is likely to have a beneficial effect on stock options.
Then, you can purchase 100 shares of ABC Company’s call option at $5 per share, an expense of $500, and an exercise price of $53. At the same time, you sell 100 call options of ABC Corporation at a price of $4.00 per share at a strike price of $56, so you get $400 from the buyer. In this way, you have paid an initial investment of 500 USD, so your initial net investment is 100 USD.
ABC stock price rises
If the stock of ABC Corporation rises to $54 (pushing the price of your long call option to $5.75 per share, and the price of the call option you sold has risen to $4.50 per share), you can decide to close your position . You can sell a long position at $575 and buy back a short call at a price of $450, resulting in a net gain of $125. Taking into account your initial expenditure of $100, your net income on this bull market spread option strategy will be reduced by $25 in trading commissions.
In the best case, the stock price may be higher than the strike price of the long and short options. In this case, you will exercise long options and expect to exercise short options against you. You will buy stocks and then turn around and sell them to buyers of your short options. The difference between the two execution prices, minus the initial expenditure and transaction costs, will constitute your profit.
ABC stock price did not rise
If the increase in ABC stock does not exceed your long-term strike price of $53 and fluctuates in the range of $50 to $52, your out-of-the-money options will depreciate as the expiry date approaches. You can decide to close your position to minimize your risk. Suppose your long options are now worth $4.00, and your short options are valued at $3.00. When you sell the option, you will get 400 USD, and you must pay 300 USD to buy back your short option. Therefore, you will get a net income of $100. After considering your initial spending of $100, you can almost break even with this bullish spread option strategy, and only pay for your transaction costs.
If you do not liquidate your option positions and do not exercise short options, they will expire and your only expenses are your initial expenses and transaction costs.
This is a way of expressing a bullish view with a limited initial cash investment. If the strategy is successfully executed, you can earn some extra money. Because this is a hedging strategy, your losses are limited.
This strategy does have some risks. On the one hand, you cannot be absolutely sure that the buyer of short options will not be against you. If the buyer exercises his call option, you will have to cash out and take out the stock. The position must be properly managed so that, in the event of an exercise, you can exercise your option when the buyer of your short call option exercises her option, so that you can take advantage of the difference between the two strike prices.
Although your short position provides you with protection, it can also be a burden if the stock price is much higher than the two strike prices and your stock is called back and cannot be sold on the open market for higher profits.
For traders who are bullish recently, buying call options on stocks is a way to benefit. The bull market spread call option strategy can help provide hedging because traders also sell call options on the same stock with the same expiration date but a higher strike price to cover the initial cost and provide a balancing effect. However, this is not a risk-free strategy.