Basic Options Strategies: Bull Call Spread (Vertical Spread) - Part Two
...Continued From Part One
Risk vs. Reward
Upside Maximum Profit: Limited
Difference Between Strike Prices - Net Debit Paid
Maximum Loss: Limited to Net Debit Paid
A bull call spread tends to be profitable when the underlying stockincreases in price. It can be established in one transaction, butalways at a debit (net cash outflow). The call with the lower strikeprice will always be purchased at a price greater than the offsettingpremium received from writing the call with the higher strike price.
Maximum loss for this spread will generally occur as the underlyingstock price declines below the lower strike price. If both optionsexpire out-of-the-money with no value, the entire net debit paid forthe spread will be lost.
The maximum profit for this spread will generally occur as theunderlying stock price rises above the higher strike price, and bothoptions expire in-the-money. The investor can exercise the long call,buy stock at its lower strike price, and sell that stock at the writtencall’s higher strike price if assigned an exercise notice. This will bethe case no matter how high the underlying stock has risen in price. Ifthe underlying stock price is in between the strike prices when thecalls expire, the long call will be in-the-money and worth itsintrinsic value. The written call will be out-of-the-money, and have novalue.
BEP: Strike Price of Purchased Call + Net Debit Paid
If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies
The effect of an increase or decrease in the volatility of theunderlying stock may be noticed in the time value portion of theoptions’ premiums. The net effect on the strategy will depend onwhether the long and/or short options are in-the-money orout-of-the-money, and the time remaining until expiration.
Passage of Time: Effect Varies
The effect of time decay on this strategy varies with the underlyingstock’s price level in relation to the strike prices of the long andshort options. If the stock price is midway between the strike prices,the effect can be minimal.
If the stock price is closer to the lower strike price of the longcall, losses generally increase at a faster rate as time passes.Alternatively, if the underlying stock price is closer to the higherstrike price of the written call, profits generally increase at afaster rate as time passes.
Alternatives before expiration?
A bull call spread purchased as a unit for a net debit in onetransaction can be sold as a unit in one transaction in the optionsmarketplace for a credit, if it has value. This is generally the mannerin which investors close out a spread before its options expire, inorder to cut a loss or realize profit.
Alternatives at expiration?
If both options have value, investors will generally close out a spreadin the marketplace as the options expire. This will be less expensivethan incurring the commissions and transaction costs from a transfer ofstock resulting from either an exercise of and/or an assignment on thecalls.
If only the purchased call is in-the-money as it expires, the investorcan either sell it in the marketplace if it has value or exercise thecall and purchase an equivalent number of shares. In either of thesecases, the transaction(s) must occur before the close of the market onthe options’ last trading day.
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