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Frederic Ruffy, Optionetics.com
February 11, 2002

Many option traders start out as call buyers.  Since investors often make a progression from the stock market to options trading, call buying makes sense.  After all, when you buy a call, you profit if the stock goes up.  In short, both stocks and calls yield profits when the stock price moves higher and, in that respect, buying a call is similar to buying a stock.  For that reason, it is natural for novice option traders to begin as call buyers.  A major difference between stocks and options, however, is that calls are wasting assets.  If the option strategist is wrong on the direction of the stock, the call option can expire worthless and result in 100% loss of one’s investment.   On a percentage basis, call buying is much riskier than buying stocks and, therefore, straight call buying can be a financially dangerous endeavor.  

One way to lower the risk of call buying is through the bull call spread.  Like call buying, the success of this strategy hinges on the stock price increasing in value.  Also, like with the purchase of a call, the bull call spread can result in a 100% loss of one’s investment.  At the same time, while call buying can provided unlimited profit (because, theoretically, there is no limit to how far a stock price can rise in price), the bull call spread has limited reward.  

At this point, the reader might wonder, “Wait a minute!  The bull call spread has the same risk, but less potential reward?  Why bother?”  Basically, while the bull call spread and call buying can yield the same loss percentage-wise, the bull spread requires a smaller dollar investment and the total potential dollar loss is, therefore, less.  To see why let us look at how the bull call spread actually works?  In this type of spread, the strategist is simultaneously buying and selling calls, on the same stock, with the same expiration dates.  The only difference between the calls purchased and those sold is the strike prices.  For instance, assume that shares of XYZ corporation and XYZ options are trading at the following prices:

XYZ stock price:  $53.00
XYZ June 55 Call:  $3.00
XYZ June 65 Call:  $1.00

Assume further that you expect XYZ to rise in price between now and when the options expire (the third Friday in June 2002).  One possible trade is simply to buy the June 55 call for $3.00 and hope the stock goes up.  Or, the strategist can simultaneously buy the June 55 call and sell the June 65 call.  In the first case, you are risking $3.00 (or $300 per contract purchased).  In the second, the strategist is a bull call spread and the trade costs only $2.00 ($3.00 to buy the June 55 calls minus $1.00 received for the sale of the June 65 call).  Either way, the trade is done for a debit.  Bull call spreads are always done for a debit—i.e., they always cost money—because the premium received for the sale of the option with the higher strike price is not enough to offset the cost for purchase of the option with the lower strike price.  In short, in a bull call spread, the strategist is buying an option and also selling a cheaper option at a higher strike price.  (Note: for simplicity, commissions have been omitted but would add to the cost of the trade in real world trading.)

In the XYZ example, if the stock fails to rise above $55.00, both options expire worthless.  In that case, the straight call purchaser loses the initial debit of $3.00.  In the case of the bull call spread, the total loss is only $2.00.  Therefore, in the worst-case scenario, the total dollar loss associated with a bull call spread is less than that of the straight call purchase (Note: Both positions can be closed at any time before expiration to avoid a total loss.)

While the total dollar risk is different for the straight call purchase and the bull call spread, the total reward potential is different as well.  Notice the table below that shows the hypothetical prices of the XYZ calls at expiration (June 21, 2002).  As the stock price moves higher, the value of both calls increase.  For instance, if the stock price rises to $70.00 a share, the June 55 will be worth $15 and the June 65 will rise to $5.00.  Therefore, at $70, the profit from the straight call purchase is $12 (or $15 – the debit of $3.00).  The spread, meanwhile, is worth only $10.00 and the profit from the bull call spread is $8.00, or less than the straight call purchase.

Hypothetical Profit/Loss of Bull Call Spread at Expiration
				Profit/Loss
Stock Price	June 55 Call	June 65 Call	Spread	Straight Call	Bull Call Spread
60	5.00	0.00	5.00	2.00	3.00
65	10.00	0.00	10.00	7.00	8.00
70	15.00	5.00	10.00	12.00	8.00
75	20.00	10.00	10.00	17.00	8.00

The bull call spread will yield less profit than the straight call purchase if the stock rises above the higher of the two strike prices (or 65).  In fact, while buying a call has unlimited profit potential, the gain in a bull call spread is limited.  The maximum gain equals the difference between the two strike prices minus the debit (or, 65-55-2=8).  Nevertheless, in the XYZ example, the straight call started outperforming the bull call spread only after the stock rose above $65 a share.  Recall that the stock price at the time the trade was entered was $53.00.  Therefore, only after a 22.6% gain in XYZ did the bull call spread yield less results than the straight call purchase.  Until that point, not only did the bull call spread involve a smaller dollar investment, it provided a better percentage return.

The straight call purchase is often the first trade a beginning option trader makes.  It makes sense to most investors because it will increase in value as a stock rises.  However, when the expectations regarding the future direction of a stock prove incorrect, the straight call purchase can result in 100% of one’s investment.  An alternative is the bull call spread, which can also result in a 100% loss, but requires a smaller dollar investment.  It involves less risk than the straight call purchase, but also offers opportunities to double and triple one’s investment dollars.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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