Considering the inherent volatility of the stock market, traders are always looking for ways to compensate for the risk that price fluctuations have a negative impact on them. In the field of options, one way to deal with this risk is to adopt the bull market spread option strategy, such as the bull market call option spread strategy.
This strategy includes buying a call option, which gives you the right to buy a stock at a fixed exercise price and sell a call option for the same stock at the same maturity date but at different exercise prices. The execution price of the call you sell is higher than that of the call you buy. This is basically a way of making long-term investments while paying part of the cost.
Similar strategies include bull-market put-spread option strategy, which is to sell a put option on the same stock and buy another put option at a lower exercise price on the same stock with the same maturity date. These strategies help traders hedge positions when they are moderately bullish. Let's use an example of call option spread strategy to see how call option strategy works.
Call option spread strategy
You expect stock prices to rise moderately in the short term, and you want to take advantage of this trend. Specifically, you expect ABC's stock to rise to about $55 in the next few months, while ABC's current stock price is $50. This may have a beneficial impact on stock options.
Then you can buy 100 ABC call options at a price of $5 per share for $500 and an execution price of $53. In the meantime, you sell 100 ABC call options at an Execution Price of $56 per share, so you can get $400 from the buyer. In this way, you can pay an initial investment of $500, so your initial net investment is $100.
ABC share price rose
If ABC's stock rises to $54 (pushing the price of your long-term call option up to $5.75 per share and the price of your call option up to $4.50 per share), you can decide to close your position. You can sell your long shares for $575 and buy back your short call options for $450, resulting in a net gain of $125. Considering that your initial expenditure is $100, your net gain on the bull market spread option strategy will be $25 minus the transaction commission.
In the best case, the stock price may be higher than the execution price of call and put options. In this case, you will exercise long-term options and expect short-term options to be exercised against you. You will buy stocks and then turn around and sell them to your short-selling options buyer. The difference between the two execution prices, minus the initial expenses and transaction costs, will constitute your profit.
ABC share price does not rise
If ABC shares do not exceed your long-term strike price of $53 and fluctuate between $50 and $52, then your cash options will depreciate as maturity approaches. You can decide to close your position in order to minimize the risk. Suppose your long-term options are now valued at $4.00 and your short-term options are now valued at $3.00. When you sell your options, you get $400, and you have to buy back your short-term options for $300. So you'll get a net income of $100. After considering your initial $100 expenditure, you will make ends meet on this bull market spread option strategy, paying only your transaction costs.
If you don't close your options and don't exercise short options, they will expire and your only expenditure will be your initial expenditure and transaction costs.
This is a way of expressing bullish views with limited initial cash investments. If the strategy is successfully implemented, you can save more money. Because this is a hedging strategy, your losses are limited.
This strategy does have some risks. First of all, you can't be absolutely sure that the buyer of a short option will not exercise his rights against you. If the buyer exercises his call option, you must compensate for it and then take out the stock. The position must be properly managed so that when exercising the option, the short-selling buyer executes the option in order to take advantage of the price difference between the two executed prices.
Although your short position protects you, it can also be a debt if your stock price is much higher than the two executive prices, and your stock is called away from you and cannot be sold at a higher profit on the open market.
For traders with short-term bullish views, buying stock call options is a way to benefit. Bull-market spread call option strategy helps hedge because traders also sell call options on the same stock with the same maturity date, but the execution price is higher to cover the initial cost and provide a balancing effect. However, this is not a risk-free strategy.