Investing in the share market can be risky even for individuals with an abundance of capital and experience While some investors choose to purchase stock outright, those who find themselves more financially strained may resort to a number of investment strategies to reduce their exposure to risk. One of these measures is the purchase and sale of options.
Options are financial contracts that provide parties with a right, but not a commitment, to either buy or sell securities (stocks, bonds, commodities etc.) at a particular price and within a specified period of time. They derive their value from that of the security involved, referred to as an underlying asset, and traders essentially place bets on whether this asset’s value will appreciate or depreciate. There are majorly two types of options that traders deal in
– Call Options – This type of contract gives the trader to buy units of a security at a certain price within a specified time period.
– Put Options – These options allow traders to sell units of a security at a predetermined price, within a designated duration of time.
This article will primarily focus on Call Options.
Call options allow investors to gain decent exposure to a security for a limited time period and with low risks. However, they can also lead to a complete loss of premium if the option expires without the security reaching the strike price. Some traders may adopt more complex approaches with respect to purchasing call options, in order to ascertain the potential value of an investment while minimizing risks and losses.
This is done by simultaneously buying and selling call options on the same security, with identical expiration dates but varying strike prices. This approach is referred to as a vertical call spread and it can be categorized into two classes based on the relative values of the strike prices involved :
– Bull Call Spread : A trader purchases call options on a security at a particular strike price, while simultaneously selling the same number of options with an identical expiration date at a higher strike price.
– Bear Call Spread : A trader purchases call options on a security at a particular strike price, while simultaneously selling the same number of options with an identical expiration date at a lower strike price.
Bull Call Spread
Let us take a closer look at Bull Call Spread. When defining what a bull call spread is, its core identifying tenets are that the premiums on the purchased options are generally higher than that of the ones sold and they always require some upfront investment. This is why it is referred to as a debit call spread.
The purchase of options at lower strike prices is referred to as the long call and the sale at higher strike prices as the short call. Together the two transactions are referred to as the call legs of the spread.
Where does it work well and where does it not?
Bull call spread strategies work well for situations with high premiums on call options and help traders minimize the threat of heavy losses if they bet the wrong way; with maximum losses being limited to the net amount expended and recovered in premiums.
The downside to this is that, though the influx of cash from the sale of the short call curtails the expenses on premiums from the long call, it also places a limit on gains as the maximum profit is capped at the strike price of the short call.
Thus, whilst cautious traders may restrict the differences in strike prices in order to reduce the net spend on premiums, they also place a limit on their gains. Conversely, more ambitious traders may build calls with a greater difference in strike prices in order to raise the ceiling on potential profits.
The potential pitfalls of bull call spreads are that traders stand to lose the entirety of premiums paid in case the security does not appreciate enough in value before the expiration date. They are also generally not an appropriate strategy for traders looking for high profits. If the underlying asset rises in value rapidly, a trader will not be able to capitalize on it because of the upper limit on profits set by the short call.
They are generally cheaper than purchasing call options exclusively and so are best applied in situations where call options are expensive and the returns expected are moderate, as the premiums on both long and short calls of the spread will help balance the net outlay of capital.
In the end, it is essential to gauge the mood of the market before committing to this type of spread as it is best applied in certain specific situations.