Here’s a simple strategy that all traders should know how to use: The bull call spread. A bull call spread is buying a call option and selling a higher strike call option against it. This creates a spread between the two strike prices with the ultimate goal of the trade to have the stock price finish above the short strike around expiration. The maximum profit for a bull call spread is the difference between the two strikes minus the cost of the trade. The most a trader can lose is what he or she paid for the spread. This occurs if the stock finishes below the strike of the long call at expiration. Generally this trade is thought of as being a short- to intermediate-term trade with three weeks to two months until expiration. Let’s look at a scenario where a trader might be able to use a Bull-Call debit spread with about three weeks until expiration.
Call option premiums are made up of intrinsic and extrinsic values. Intrinsic is the difference of the current stock price minus the strike price. Extrinsic is the difference between the option premium and the intrinsic value. Extrinsic value is also called time value. There are two things about time value. The first is the closer an option is to expiration the faster the time value of an option evaporates. The second is, the closer a strike is to being at-the-money the more time value it will have and thus the faster it will decay as well.
The outlook on the underlying stock for this set up should be bullish to neutral. One of the hardest parts about a bull call spread is figuring what strike price to buy and sell. One way is to sell the strike that equates with the furthest expected move for the stock within the described time period.
For example, imagine the stock’s current price is $37. The trader sees resistance up around $40 a share. Thus the trader would sell the 40 strike and buy the 35. The ITM long call (35 strike) will have a higher premium than the short (40 strike) call, but the short call is all time premium at this point. As the underlying rises to the short strike and expiration approaches, the short call will lose time value at a rapid rate, while the ITM call will retain its value well. Because of this, the trade is both a directional play and somewhat of a time play.
Breakeven on the trade is the long strike plus the cost of the trade. If the stock goes up the trader can close out the trade (hopefully at a profit) before expiration; but to reap the most of the potential gain, the trader will have to hold the spread until close to expiration. The trader is profitable as long as the stock stays above the breakeven point. Below that point, the trade becomes a loser. Traders can attempt to stave off losses by closing failing trades before expiration in the spirit of “take your losses early and let your profits run”.