Business Finance

Investment Strategies: Bull Spreads

Written by Gregory Steffens for Gaebler Ventures

By combining call and put options in various ways, equity investors are able to hedge certain risks involved in their portfolios. Various strategies use spreads which involve the purchase and sale of options with either different exercise prices or expiration dates. One particular type of spread is a bull spread, a strategy which profits from increases in a particular stock price. This article introduces the option strategy of bull spreads, how they are created, and how investors profit from their designs.

Strategies with options having different expiration dates are considered time spreads while those using options having different exercise prices are called money spreads.

This article focuses on the latter.

Money spreads involve the purchase of one option with a given expiration and exercise price and the sale of another option with the same expiration but different exercise price. They are called spreads since they profit from the difference, or spread, between the two options' exercise prices.

Bull Spreads

Bull spreads are a type of option strategy that involves buying a call with a lower exercise price and selling a call with a higher exercise price.

They can also be created using puts by purchasing a put with the lower exercise price and selling a put with the higher exercise price; however, this article will follow the former method using calls.

Indicative by their name, bull spreads attempt to capitalize on a bull or value increasing market. Consequently, if the market price of the particular stock decreases, a bull spread will have a negative value.

The chart below illustrates the profit profiles for a bull spread's two components, a short call with a $40 exercise price and a long call with a $35 strike price. These strike prices could be anything as long as the short call has a higher strike price than the long call.

Through the combination of these two call options, the profit profile for a bull spread can be shown. The below example capitalizes on the spread between a stock's prices of $35 and $40.

Since the call options differ in their exercise prices, their premiums demand different prices. For this instance, an investor purchases the $35 call option for $200 and sells the $40 call option for $100. This discrepancy results in the strategy's possibility of losing money if the stock price decreases. That lose potential, however, is limited to $100 due to the strategy's design. Moreover, the break-even point shifts so that the investor does not realize a profit until after the price rises above the $36 point.

From that point until the price reaches $40, the strategy gains value; however, no further profits can be made from increases in the stock price past the $40 mark. The maximum profit potential for this investor would be $400.

Since investors only realize positive profits from price increases in the underlying stock, bull spreads should be used when an investor is relatively confident that the stock's value will rise during the life of the options. Even if the desired movement does not occur, the bull spread's design protects investors from substantial losses which is the key reason for their use.

Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.

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