Bull call spread, also called long call spread or debit call spread, consists of a long call option with lower strike price and a short call option with higher strike and same expiration. It is a bullish option strategy (makes money when underlying goes up) with limited risk (equal to net initial cost) and limited potential profit (equal to strike difference minus net initial cost).
- Buy a call option (more on strike selection below).
- Sell a call option with higher strike, on the same underlying, with same expiration date.
Two important things define a bull call spread:
- Both options have the same expiration date (it is a vertical spread).
- The short call has higher strike than the long call (otherwise it would be a bear call spread – the inverse strategy).
Bull call spread is a debit strategy. Its initial cash flow is negative.
It equals cash received from selling the higher strike call minus cash paid for buying the lower strike call.
Initial CF = short call price – long call price
Because the former can’t be greater than the latter (call option prices decrease with increasing strike), net cash flow is negative. Selling the higher strike call helps reduce the cost of the long lower strike call, but it never pays for it completely.
Payoff at Expiration
With a bull call spread there are three different scenarios at expiration:
The worst case is when underlying price ends up below or at the lower strike. Both options expire worthless. The trade results in a loss equal to initial cost, which is also the maximum possible loss.
The best case and maximum possible profit is when underlying price ends up at or above the higher strike. Both options are in the money and worth the underlying price minus the particular strike. Therefore, the difference in their values (and net payoff from the spread) equals the difference between strikes. Net profit equals the strike difference minus initial cost of the position.
The third scenario is when underlying price is between the two strikes. Only the long call is in the money (and worth underlying price minus strike). The short call expires worthless. Total result from the trade equals long call payoff (underlying price minus lower strike) minus net initial cost. It can be a profit or loss, depending on how high above the lower strike underlying price is.
The break-even point is when the payoff from the long call equals net initial cost of the entire position.
Call payoff = net initial cost
B/E underlying price – lower strike = long call initial price – short call initial price
B/E underlying price = lower strike + long call initial price – short call initial price
Below the break-even the position makes a loss; above it makes a profit.
For more details and examples of payoff calculation, see Bull Call Spread Payoff, Break-Even and R/R.
When to Trade
The objective with a bull call spread is for underlying price to end up above the higher strike at expiration – that is when the position makes its maximum profit. Further increases in underlying price have no effect, because above the higher strike both options increase in value at the same rate.
Therefore, bull call spread is a suitable strategy when we expect underlying price to moderately increase.
If we expect a greater increase, it may be better to not sell the higher strike call and just buy a plain and simple long call.
Strike selection is essential, because it has huge effect on the position’s risk, potential profit, and exposures to factors like underlying price, volatility, and passage of time (measured by the Greeks).
We can break down the strike selection decision in two parts:
- Where = Which strikes relative to current underlying price.
- How wide = How big distance between the two strikes.
With the first decision we have three possibilities:
- Both strikes above current underlying price.
- Both strikes below.
- Long strike below and short strike above.
These result in very different exposures – almost like completely different option strategies!
Both Strikes above Underlying Price
If both strikes are above underlying price when opening the spread (#1), both options are out of the money, which means their premiums are lower (and the difference between the two premiums is small). Net initial cost (and maximum risk) is relatively low.
The trade-off is that we need a bigger increase in underlying price for the position to be profitable.
Another important implication is that the long lower strike call has greater time value than the short higher strike call (because it is closer to the money). As a result, the spread has positive vega and negative theta.
In other words, when volatility increases, the value of the spread goes up. But when underlying price stays the same and time passes, the position loses time value. This makes sense – we need underlying price to move, so volatility works for us, while time works against us.
It may seem that this is always the case with bull call spreads, but it is not.
Both Strikes below Underlying Price
If we open the spread with both strikes below current underlying price (#2), both options are already in the money. They are more expensive and (more importantly) the difference between their premiums is greater. The position has greater initial cost and greater risk.
The good thing is that underlying price is already where we want it – if it stays the same until expiration, we get the maximum possible profit from the spread. Unlike the previous case, time works in our favor, while volatility works against us. We don’t want the market to move. The position has positive theta and negative vega.
Underlying Price between Strikes
When we choose the long strike below and the short strike above the current underlying price (#3), the position’s characteristics will be somewhere between the two cases explained above.
In general, if the long strike is closer to underlying price, the long option’s time value will be greater, and the position will be closer to case #1 (long volatility). If the short strike is closer to underlying price, it will be more like #2 (short volatility).
If both strikes are approximately the same distance from current underlying price, both options have approximately the same time value, and the position’s total exposure to time and volatility (theta and vega) is close to zero.
In other words, if you are using a bull call spread primarily as a directional play and want to minimize volatility exposure, select such strikes that current underlying price is approximately in the middle.
While the position of both strikes relative to underlying price affects exposures to volatility and time, distance between the two strikes affects the size of risk and profit potential.
The further apart the two strikes are, the greater initial cost, risk, and potential profit.
Consider two extreme cases:
If both strikes are the same (we buy and sell the same option), we have zero position, zero risk, and zero profit potential.
Conversely, if the long strike is zero and the short strike is infinite, we have a position quite similar to being long the underlying (not assuming things like dividends), with high cost, high risk and infinite profit potential.
- If you are more bullish or expect greater volatility, choose higher strikes.
- If you expect lower volatility, or expect the underlying to “not fall” rather than “go up”, choose lower strikes.
- If you want the position neutral on time and volatility, choose the long strike below and short strike above current underlying price, approximately the same distance.
- If you are conservative, choose strikes close together.
- If you can risk more, and want more profit potential, choose strikes further apart.