by Dawn Pennington 07/29/08
This strategy helps you to save money on the long call. You may be OK with paying a buck or two per share to buy a call option, but many investors start to shy away from options when they get into the $4 or $5 range.
But let's say the long 22.50 Call is trading for $4 -- that's money you pay to enter the trade. But let's also say that the 25 Call is trading for $3. Basically, you spend four bucks to buy the long call and collect three bucks on the short call. You have now just spent one dollar to bet that the stock is going to trade up to $25 before options expiration.
Your profit is dependent upon the stock finishing somewhere between the two strike prices (in this case, $22.50 and $25). At the very least, you want the stock to go to $23.50, which is your breakeven point (that figure comes from adding the lower strike price of $22.50 to the $1 you paid for the spread). Anything above that, up to $25, is profit.
If the stock goes above $25, the bull-call spread limits your profits because your short call was, in effect, a bet that the stock wouldn't trade above $25.
This is why you may just want to buy the call outright (and not establish a spread) if you think the stock will make a more-dramatic move, as the short call serves to cap your upside.
However, because all trades don't work out (even though we wish they would!), your downside is capped, too.
What if the stock takes a huge tumble and goes to $20 -- which is well-below your long call's exercise price? Unfortunately, you're out of luck because both options are now out-of-the-money.
The long call at $22.50 gives you the right to buy shares at that price, but if they're only trading for $20 on the open market, the call -- and, in turn, the spread -- is worthless.
But to your advantage, you've only lost a buck (or $100 per contract) on the investment if the stock tanks. And that would hurt far less than losing the $4 that just buying the long call outright would have cost you!
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