Bull Call Spread concept explanation, how to profit intelligently when you expect stock price to rise.
Let us say the property prices in a particular area are increasing every few days and there are a lot of buyers.
You are an expert in property and think that the prices of 3 particular houses might double in the next 30 days. If it doesn’t double in the next 30 days then price can go down.
This leaves you in an interesting position, you have a solid view on the houses for 30 days BUT only for the next 30 days.
You can utilize a Bull Call spread to take advantage of your view on the prices, while limiting your losses if you are wrong.
Technical explanation, we will simplify it right after this:
A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains. Commodities, bonds, stocks, currencies, and other assets form the underlying holdings for call options.
Source: Investopedia
Understandable explanation:
- You expect the house prices in an area to go up in next 30 days, otherwise they might fall.
Risks and Problems if you buy the houses:
- You don’t have the money required to buy all 3 houses
- The view is either the prices will increase in the next 30 days and after this time they might not.
- The risk of buying all the properties and the prices not rising are also very high because it will take up a big chunk of the capital. Limiting your ability to invest in other opportunities.
It is an opportunity with a big risk.
Being the property market expert, you start looking at ways that you can cut your risk down and hopefully make money based on your insight and loose very little money if your view is wrong.
Let us make some assumptions:
- Price of each house is 1000
- There are multiple buyers for the houses.
- The house owners want to sell at a price higher than what they are being offered currently i.e. they want to sell the house at 1100.
- The house prices are printed in a newspaper, based on sales in the area.
You go to the house owners and give them 50 Rs. to let you buy the house for 1100 if price crosses 1100 in 30 days as per the newspaper. They are earning rent from their house/stock. Detailed explanation: click here
This is called buying a CALL option. Detailed explanation click here
At the same time you speak to the multiple buyers and convince them to buy the house if price of the house, in newspaper, becomes more than 1250 and they pay you 25 Rs.
This is called SELLING/WRITING a CALL. Detailed explanation click here
Why would they do that? They think that if price crosses 1250 then price will rise to 1500 and want to risk only 25 Rs.
We have now setup a Bull Call spread.
What exactly are we doing in terms of shares:
- Buying a Call option
- Strike Price: 1100
- Premium Paid: 50 per share
- Sell/Write a Call option
- Strike Price: 1250
- Premium Received: 25 per share
- You don’t need the house owners(share owners) permission to buy the house(shares) at 1100 in this scenario the market regulators facilitate this.
| House Price (Share Price) |
Purchase Price: (Our) |
Rent Paid (by us) |
Purchase Price: (Other Buyers) |
Rent Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,100 | No Purchase | 50 | No Purchase | 25 | -25 | |
| Price of house at the end of the month | Price did not go above 1100, we did not purchase the house | Rent paid by us to house owner. | Price did not go above 1250, the other buyers did not purchase the house from us. | Rent received by us. |
Rent Received – Rent Paid = 25 – 50 = -25 The price is at 1100, we tell the house owner to keep the rent. The price is below 1250, the buyers tell us to keep the rent as they can buy the house cheaper in the market |
|
| House Price (Share Price) |
Purchase Price: (Our) |
Rent Paid (by us) |
Purchase Price: (Other Buyers) |
Rent Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,140 | 1100 | 50 | No Purchase | 25 | +15 | |
| Price of house at the end of the month | Price is above 1100 price:
we buy the house from house owner at 1,100 |
Rent paid by us to house owner. | Price did not go above 1,250, the other buyers did not purchase the house from us. | Rent received by us. |
House Sale Price – House Purchase Price + (Rent Received – Rent Paid) = 1,140 – 1,100 – 25 – 50 = +15 The price is at 1140, we buy the house from the house owner at 1100 and sell on the market for 1140. The price is below 1250, the buyers tell us to keep the rent as they can buy the house cheaper in the market |
|
| House Price (Share Price) |
Purchase Price: (Our) |
Rent Paid (by us) |
Purchase Price: (Other Buyers) |
Rent Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,500 | 1,100 | 50 | 1,250 | 25 | 1100-1250 -25 = +125 | |
| Price of house at the end of the month | Price is above 1100 price:
we buy the house from house owner at 1,100 |
Rent paid by us to house owner. | Price is above 1,250, the other buyers purchase the house from us at 1250. | Rent received by us. |
House Sale Price(To other buyers) – House Purchase Price + (Rent Received – Rent Paid) = 1,250 – 1,100 – 25 – 50 = +125 The price is at 1,500, we buy the house from the house owner at 1100 and sell to the other buyers at 1,250 as agreed.
| |
Maximum loss in above example is -25.
We can generalise maximum loss in a bull call spread:
Maximum Loss in a bull call spread is the difference in rent we pay to the house owner and the rent we recieve from other interested buyers.
In stock market terms:
Maximum Loss in a bull call spread is:
Premium Paid – Premium Received
Maximum profit in the above example is: 125
We can generalise the maximum profit in any bull call spread:
Maximum Profit in a Bull call spread is the difference between our selling price agreed with other buyers minus our agreed purchase price with the house owner minus our rent paid and received.
In stock market terms:
Maximum Profit in a bull call spread is at or above the strike price we sold:
Buy Call Strike – Sell Call Strike + Premium Paid – Premium Received
This strategy is also called a poor man’s covered call.
The above scenario is only for demonstration, the changes of finding such a high risk reward ratio are extremely low.
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Covered Calls explanation using a house. Concept explanation click here