Bull Call Spreads How to Video

Hello, my name is Brian Overby. I am the Senior Options Analyst at TradeKing, and author of The Options Playbook. Today I’d like to highlight one of the plays that is inside The Options Playbook called bull call spreads. There are many different names for bull call spreads. They also are known as long vertical spreads, and oftentimes referred to as a long call spread. The convention inside the Playbook is to actually call it a long call spread, so I’m going to use that convention going forward.

So, long call spreads, why would I want to do a long call spread? I think a great example to talk about to get into long call spreads is to compare them to just buying a call outright. If I go out and I want to buy a call, let’s use a fictitious stock, let’s say that xyz is trading at $50 and I am bullish on the underlying, I might go out and buy an at-the-money call.

Let’s pick an expiration. Let’s say we’re going to go out one month in time. Now, that expiration is going to depend on your forecast, but here for our example we’ll just use a one-month option. Obviously, if you are longer term bullish you might go out and use a nine-month option contract. There are a plethora of different expirations available.  The main way to choose your expiration is to think about when you expect something to happen in that underlying stock, be it on your chart, your Fibonaccis, your Bollinger Bands, or maybe a specific event like earnings coming out.

So we have a one-month call option, stock’s at 50, strike is 50, and we’re going to go out and buy that call option and hope that the underlying market goes up. Now, when I look at that price on that call option, some people might think at-the-money options contracts are fairly expensive, so if I do think that and I want to lower that cost, how can I do that?

Well, the at-the-money call option is a right. It’s a right to buy that stock over that one-month period of time at that strike price of 50. Okay, now that debit that I paid for it is the maximum risk of that trade—also got to throw in any commissions that might happen. You always want to take commissions and taxes into any type of strategy that you’re looking to do.

Now, if I want to lower the cost of that trade what I might do is buy that 50 strike call, but at the same time I’m going to sell the 55 strike call. All right, so that sale of that call brings on an obligation, but it also gives me cash. So the buy of the call is a right, it’s a right to buy 100 shares of the underlying at 50 over that one-month period of time. The sale of the 55 call is an obligation. It’s an obligation to sell 100 shares of stock at 55.

The major difference between doing the long call spread versus buying the call outright is that if I go on out and do the spread, I can lower my overall cost. And guess what that does? That lowers my overall max risk. So when I enter the spread in on the TradeKing platform—you can do this all as one trade, send this down as a package to the trading floor and say, I would like to buy the 50 strike call, sell the 55 strike call at a net debit to my account.

Now, be aware that if you are doing strategies with two legs, leg one is the buy, leg two is the sell, that might incur multiple commissions and have complex tax treatment, so just be aware of that and add that in to any of your strategies that you’re looking to do.

Some of the good news and the bad news, as far as long call spreads compared to buying a call outright, one of the best benefits of the long call spread is the way that it reacts to time erosion in the option contracts. If you buy an at-the-money option, you just buy that outright. Each day that passes—and let’s say the underlying stock doesn’t move at all—that option is eroding, that time value that you purchased in that option contract is eroding. I like to think of it as an ice cube sitting in the hot sun. As that water evaporates from the ice cube and it gets smaller and smaller, it’s a lot like your option contract as you’re sitting there waiting for the underlying stock to move.

Now with a long call spread, I’ve bought one option and I’ve sold one option, so if time decay is hurting the one that I bought, it is helping the one that I sold. Also, the net debit is the max risk.  We’ve already talked about that. But the downside of actually going out and doing a call spread is that I have limited and known upside on that trade, so, that 55 strike is an obligation, and that also means that the maximum that the strike could be worth is 5 points, the difference between the strikes. So I lower the overall max risk of the trade, and just like in almost all option strategies, if you get lower risk you usually get lower upside, and that’s the case with the long call spread.

My name is Brian Overby. I am the Senior Options Analyst at TradeKing, and author of The Options Playbook. If you’d like to learn more about investing, please check out our education center on tradeking.com, the companion website for my book, optionsplaybook.com, and our Trader Network, where investors connect to share ideas and strategies for trading stocks, options and more.