Playbook: Spreads: the Bull Call

Bull Call

The bull call is a vertical debit spread (you will have to pay for it). It is a long call ‘protected’ on the downside by a short call. The short call reduces also your cost. The disadvantage is that you cap potential on the upside, so you don’t want underlyings to go up very high (lost potential).

The long call you buy is closer ATM or ITM (0.60 delta), so more expensive than the OTM short call (0.40 delta) for which you get paid. Therefore it is a ‘debit play’ (you pay for the set-up).

You typically buy a bull call 3-6 months before expiration. The main reason is that you don’t want to be impacted by time decay (which is highest in the last month). In addition, your underlying must move upwards in order to reach the break-even point. So you want to give the pay more time to be right. And you want the breakeven point to be realistically achievable.

The bull call is the opposite of the bear put.

The position benefits most from IV/IVR expansion and/or moderate underlying price increases to or slightly above the strike.

Considerations

General

The strategy looks to take advantage of an increase in price from the underlying asset before expiration.

Bull call spreads benefit from two factors, a rising stock price and time decay of the short option. Increased implied volatility may also benefit the bear put debit spread.

A bull call spread is the strategy of choice when the forecast is for a gradual price increase to the strike price of the short call.

These are the considerations for entering a bull call:

• The expectation that underlying (stock, ETF, index, future) will rise: the outlook is clearly bullish.
• Implied Volatility (IV)/IVR (IV Rank) is low (<30), looking for options to increase in value over time*
• You can make a better return than if you had bought the underlying itself.
• Executing a bullish trade for a capital gain at reduced maximum risk due to that you sell a call as well.
• It’s difficult to sell (‘short’) premium, so it is a leveraged alternative to selling/shorting the underlying.
• Bringing down the cost , risk, and breakeven on the trade compared to buying (only) the long call.
• Wanting to stay engaged after having reached maximum portfolio allocation for (e.g.) short premium strategies.
• The underlying has just experienced a pullback/decline, which gives you a strong entry.
• Hedging against bearish/short positions.
• Risk is limited (‘defined’) to the premium paid (‘debit’).
• The maximum reward is capped to the premium paid (‘debit’).
• When you buy and therefore own an option, you are exposed to time (value) decay (‘hurts’), so typically, expiration dates should be reasonably far away (so >90 up to 180 DTE or even higher) to give you more time and a chance of the option increasing in value; so the period to trade is at least three months, preferably longer.

* Note: because you’re both buying and selling a call, the potential effect of a decrease in implied volatility will be somewhat neutralized.

Description

Set-Up

1. ‘ Buy to open’ (BTO) the call option ( in US 1 contract = 100 shares) ITM at 0.60 delta (up to ATM so below the underlying price)
2. ‘Sell to open’ (‘STO’) the call option at 0.40 delta, so higher and above the underlying price. Since it is very difficult to find 0.4 delta set-ups fitting all criteria, I often skew to 0.5o delta, but this further reduces my profit potential.

• Sell the same number of strikes
• Arrange both call strikes equidistant from the underlying price, or skew for a better breakeven, to create a debit that’s (slightly more than) half the width of the spread.
• The further out-of-the-money the short call of the bull call debit spread is initiated, the more aggressive the outlook.
• Don’t go below 50% PoP.
• Intrinsic value long call >= Net debit (or: long call value – EXT long call (mid) >= Net Debit); to break even on the position, the stock price must be above the long call option by at least the cost/premium to enter the position.

Related Options Strategies

The bull call combines a long call and a short call at the same expiration date, and is one of the four vertical spread strategies (the other ones are: bear put, bear call, and bull put) and the basis for many other (horizontal and diagonal) spread and ratio strategies, long condors and butterflies.

Long call positions perform well when the underlying makes big increases, in the short term. Bull call debit spreads require time to fully realize profits, so are medium- to long-term. They outperform long calls, as long as the underlying price increases moderately and remains at or just below the short call, halfway to/near expiration. They are less expensive than buying only the lower call strike, and (may) result in a larger percentage of profit than purchasing only the lower strike (if the underlying price increases moderately).

The Greeks

A bull call spread performs best when the price of the underlying stock goes above the strike price of the short call at expiration. Therefore, the ideal forecast is “modestly bullish” or “net positive delta.”

Because a bull call spread consists of one long call and one short call, the net delta changes very little as the stock price changes and the time to expiration is unchanged (“near-zero gamma”).

Bull call debit spreads benefit from an increase in the value of implied volatility. Higher implied volatility results in higher options premium prices. Ideally, when a bull call debit spread is initiated, implied volatility is lower than it is at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bull call spread consists of one long call and one short call, the price of a bull call spread changes very little when volatility changes (“near-zero vega”).

Time decay, or theta, works against the bull call debit spread. The time value of the long options contract decreases exponentially every day (faster than the short call). Ideally, a large move-up in the underlying stock price occurs quickly, and an investor can capitalize on all the remaining extrinsic time value by exiting the position. Since a bull call spread consists of one long call and one short call, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or below the strike price of the long call (lower strike price), then the price of the bull call spread decreases with the passing of time (and loses money). This happens because the long call is closest to the money and decreases in value faster than the short call. However, if the stock price is “close to” or above the strike price of the short call (higher strike price), then the price of the bull call spread increases with the passing of time (and makes money). This happens because the short call is now closer to the money and decreases in value faster than the long call. If the stock price is halfway between the strike prices, then time erosion has little effect on the price of a bull call spread, because both the long call and the short call decay at approximately the same rate.

GREEK

+/-

Notes

Profile

Delta (direction speed)

+

Positive (speed) and is at its fastest in between the strikes. Notice how delta slows down when the position is deep ITM or OTM.

Gamma (acceleration)

+

±

Peaks below the lower (bought) strike and peaks inversely above the higher (sold) strike.

So, positive below the breakeven point, which leads to delta growth when the underlying price approaches the breakeven point. Above the breakeven point, gamma becomes negative, thereby decreasing delta.

Theta (time decay)

–

±

Time decay is harmful to the position when it is OTM and helpful when it is ITM.

Vega (volatility)

+

±

Volatility is helpful to the position when it is OTM and harmful when it is ITM.

Rho (interest)

+

Positive, higher interest rates
are generally helpful
to the position.

Entry Rules

Profitable bull calls require correctly selecting bullish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR below 30%.
• Bull call debit spreads can be entered at any strike price relative to the underlying asset. In-the-money options will be more expensive than out-of-the-money options.
• Ensure the trend is upward/bullish: above SMA 20 and above the MACD line
• Ensure at least three other technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bullish
2. Support & Resistance = the underlying has just experienced a pullback/decline to clear support level
3. RSI = oversold
4. SMA 20 and MACD
5. Bollinger Bands in combination with Keltner Squeeze: at the bottom and outside Keltner bands
6. ADX/DMI: increasing up and above 20
7. ATR low

P/L and Risk Profile

Net Position

Net debit, because you pay to buy the put option.

Theoretical Profit

The maximum reward is the difference in strikes (or ‘spread width’) -/- net debit.

As the stock price rises, the Bull Call moves into profit and reaches the maximum profit when the stock rises to the higher strike price.

The reward is capped/limited when the underlying price reaches the short call strike.

Theoretical Risk/Risk Profile

The maximum risk is the price you initially pay for the bull call (‘net debit/premium’) which is the difference between the net debit paid for the long call less the net credit received for selling the short call.

This is realized if the underlying price is below the long call.

Breakeven

Lower call strike + net debit.

Managing and Closing Position

Bull call debit spreads have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, or fast enough, or volatility decreases, the spread will lose value rapidly and result in a loss. Bull call spreads can be adjusted like most options strategies but will almost always come at more cost and, therefore, add risk to the trade and extend the break-even point.

Halfway to/Near Expiration

• If the underlying price increases to/slightly above the short call (higher strike) profit increases because the short call is now closer to the money and decreases in value faster than the long call: both calls are ITM and the maximum profit = spread width – net debit (‘theoretical profit’).
• If the underlying decreases below your stop/loss, sell the long call or close the position.
• If the underlying is between the call strikes and decreases towards or below the long call (lower strike), the losses increase, because the long call is now closer to the money and decreases in value faster than the short call.
• If the underlying is close to the long call (lower strike), losses further increase because the long call is closer to the money and decreases in value faster than the short call.
• If the underlying decreases to below the long call (OTM): both expire worthless, and the loss will be the net debit (theoretical risk).

Rules for Managing/Adjusting Position

• Set alerts on breakeven/predetermined targets
• If the PoP is <33%
• 1% rule: stock within 1% or short put/call: manage the position.
• At 21 DTE.
• If the underlying price goes against you so decreases:
  • roll the untested short call down for extra credit (same expiration), but never below breakeven.
  • or, if the underlying price goes down/decreases fast: ‘leg out’ (BTC) the untested short call for a fractional debit and hold the long call (if you expect an increase in the underlying price).
  • or, a bear put debit spread could be added at the same (long) strike price, and expiration as the bull call spread. This creates a reverse iron butterfly and allows the put spread to profit if the underlying price continues to increase. However, the additional debit spread will cost money and extend the break-even point.
  • or close position, and open bear put(, or bear call), based on the same entry rules you use normally.
  • or check whether you can do a ‘pendulum adjustment’ by selling the long and buying the long on the other side when between strikes:  so creating a bear call (don’t roll the short: this will be at a cost and makes no sense (it will go ITM, you want OTM).
• If the underlying price is going in the right direction, so increases:
  • never leg out if the underlying price goes up/increases fast: lock in profits by purchasing the put counterpart (for a fractional debit), adding risk to the initial strategy, neutralizing the portfolio’s ∆β to rebalance (improve the statistical edge).
  • if the underlying asset is expected to continue to rise strongly beyond the strike price of the short call option, one could also choose to buy to close the out-of-the-money short call option and then simply allow the long call option to continue to gain in value.
  • if you have seen a large percentage of profit on a spread that still has a lot of time left, you could elect to take profits and buy a new spread that is further away (even higher strikes)
• Never roll the entire spread out in time.
• Contrary to the credit spread you can NOT buy back only the short call.
• If this is not workable: allow the limited risk probabilities to play out.

Rules for Closing Position/Exiting the Trade

• For a 50% profit
• Close before the final month before expirations (to avoid time decay), so not later than around 35 DTE.
• If the short call is ITM and its corresponding put value < the dividend.

Mitigating a loss

• To hedge/recover losses you open a high probability position, using a strategy that favors neutralizing the portfolio’s ∆β, to rebalance and create an overall statistical edge, reduce costs or maintain profits (this is always the goals when adding risk to manage limited risk strategies).
• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% of the premium paid; if the underlying falls below the stop loss, exit by selling the calls.

Additional Notes

Advantages

• Reduced risk, cost, and breakeven point for a medium- to long-term bullish trade
• Cheaper than buying the stock or buying a call alone.
• Capped downside
• The farther away from expiration, the more downside protection in the event the stock declines rapidly.

Disadvantages

• Only higher yields if you select significantly higher strikes AND the underlying stock price rises up to the higher of those strikes.
• Capped upside if the stock rises (loss of opportunity).
• The farther away from expiration, the slower the maximum returns made ( = price one pays for downside protection).

Exercise/Assignment

The short call can be assigned at the ex-dividend date in the event the short call is ITM, and its corresponding put value < the dividend. This results in (probably unwanted) stock: in that case close the 100 short shares and a long call as a single Covered Call order.

The risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long call in a bull call spread has no risk of early assignment, the short call does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.

Therefore, if the stock price is above the strike price of the short call in a bull call spread (the higher strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways:

1. The entire spread can be closed by selling the long call to close and buying the short call to close.
2. The short call can be purchased to close, and the long call can be kept open.

If early assignment of a short call does occur, stock is sold. If no stock is owned to deliver, then a short stock position is created. If a short stock position is not wanted, it can be closed by either buying stock in the marketplace or by exercising the long call.

Note, however, that whichever method is chosen, the date of the stock purchase will be one day later than the date of the stock sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

Source: Fidelity Learning Centre

The long call can be ‘exercised’. For this, you need to contact your broker.