If you think a stock is going to rally, then buying a call option is a smart way to go.
By buying a call option, you gain exposure to that up move for a fraction of the cost compared to buying shares.
And your risk is limited to the amount you paid for the option.
However, there’s also a downside…
Options expire, so the clock is ticking as you wait to see if you get the move you’re hoping for.
If things don’t pan out within your time frame, time decay could eat up the value of your option. It could even expire worthless.
You also have a higher breakeven because you need to recoup the cost of buying the option.
These are a couple of reasons you might want a strategy with a little more nuance than simply buying a call option.
So today, let’s look at a way to put the odds in your favor…
Adding Another Leg
A “bull call spread” adds a second layer to your options trade.
With this strategy, you buy a call option. Then you sell a call option at a higher strike price.
Both options use the same expiry date, and you enter both legs at the same time.
The premium you receive from selling an option partially offsets the cost of buying the other option.
So you lower your breakeven, giving your trade a higher chance of success.
To see how it works, let’s check out the chart of Alphabet (GOOGL) below…
Alphabet (GOOGL)
Source: e-Signal
Say you believe that GOOGL is going to rally, and you want to take part in that move. (Please note that this is just an example, not a recommendation.)
You decide to buy a call option with a $170 strike price with around two months to expiry. That costs you $5.50, which equates to $550 (option contracts cover 100 shares).
That means the breakeven on your trade is $175.50. That’s the option’s strike price ($170) plus the option premium ($5.50).
In this case, GOOGL has to trade above $175.50 before you begin to profit.
This is where the second leg of the strategy comes into play and helps lower your breakeven…
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Working the Numbers
In addition to buying the $170 call option, you also sell a call option with a $180 strike price. In exchange, you receive $2.20 (or $220 per contract).
That lowers the breakeven on your trade to $173.30.
So now GOOGL only has to trade above $173.30 before you profit.
But this does come with a catch. The $180 sold call option locks you into handing over 100 shares at $180 per share if exercised.
The maximum profit you can make is the difference between your options’ strike prices ($170 and $180 = $10), minus the money you paid out for the spread ($3.30). That equals $6.70, or $670 per contract.
Of course, I’ve used the $170 and $180 strikes in this example. But you can try different combinations to find the spread that best suits your needs.
In the end, a bull call spread is a trade-off…
You give up the potential for larger profits than if you had just bought a call option by itself.
But you also gain exposure to a potential up move with better odds of it playing out in your favor.
And that could make all the difference depending on the scenario you’re facing.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict