The long call spread is a relatively conservative way to bet on stock gains
We have long trumpeted the advantages of speculating on stocks with options, as these vehicles provide leverage and flexibility. The long call spread, or bull call spread, is a great example of both of these traits. The spread involves buying to open a call, and simultaneously selling to open a higher-strike call in the same series. By selling that call, you can reduce your cost of entry -- which represents your maximum risk -- as well as your breakeven on the bullish trade. However, you may have to sacrifice some profits in the event of a bigger-than-expected rally.
Let's look at how it works. Let's say Stock XYZ is trading at $138, and our theoretical trader expects it to go higher in the short term. However, earnings are approaching, and ramped-up volatility expectations translate into higher option premiums. Instead of simply buying a call outright, our trader decides to initiate a long call spread.
The April 140 call has an ask price of $3.30. Since each option represents 100 shares, this trade costs $330. To make it a bull call spread, he simultaneously sells to open the April 145 call, which is bid at $1, or $100. This brings the net debit on the trade to $2.30, or $230.
To profit on the spread, the trader needs XYZ to move above $142.30 (bought call strike plus premium paid) before April options expire. Had he simply bought the 140-strike call, his breakeven would be $143.30. Meanwhile, should XYZ shares move lower, the most the spread will lose is $230, compared to $330 for the lone call buy.
The downside, however, is that the bull call spread's profit is capped thanks to the sold 145-strike call. Should XYZ skyrocket to $150 before expiration, the spread's profit would max out at $2.70, or $270 (difference between strikes minus net debit). A buyer of just the 140-strike call, on the other hand, would be holding an option with 10 points of just intrinsic value, or roughly $1,000. Minus the $330 paid for the call, that's a profit of $670.
As you can see, a long call spread is an intriguing bullish strategy if you have an idea of where a stock may lose steam. Plus, its relatively low cost of entry -- and, thus, maximum risk -- is incredibly appealing when options premiums are pricey. As long as you're comfortable sacrificing the theoretically unlimited profit potential of a "vanilla" call purchase, a long call spread may be the move to make.