Bull put and bull call spreads are options strategies that are designed to take advantage from a rise in the price of a specific stock. These strategies present a different kind of risk/reward profile from simply purchasing the stock in question and are more suited for traders who wish to bet on a specific price range as opposed to a general advance in the stock price.
Option Basics
An option gives the holder the right, but not the obligation, to buy or sell a specific quantity of a particular stock at a predetermined price and date. A call option provides the right to buy the stock, while a put option gives the holder the right to sell. A call with a strike of $10 for 100 Ford shares, expiring on Aug. 10, allows the option holder to buy 100 shares of Ford at $10 each on Aug. 5 from the person who wrote the option. Such an option will be exercised only if Ford is trading at more than $10 in the open market. If the prevailing price of Ford is less than $10, it is cheaper to buy Ford through a broker. A put option at $10 with the same characteristics would allow the holder to sell 100 Ford shares at $10 and is valuable only if Ford is trading at less than $10 on Aug. 5.
Bull Call Spread
When you structure a bull call spread you buy a call with a lower strike price and sell a call with a higher strike price, expiring on the same date. An example would be buying a Ford call at $10 and selling a Ford call at $12. If the price of Ford shares is less than $10 at expiration, neither option is exercised and you will lose money, because the option you bought must have cost more due to its lower strike than the option you sold. This is your maximum loss. If the price of Ford is more than $12 at the date of expiration, you make more money from the option you bought that you lose from the option you sold, resulting in the maximum possible profit. For price levels between $10 and $12, you may break even, make or lose money.
Bull Put Spread
In a bull put spread, you sell a put option with a high strike price and buy a put option with a lower strike price; for example, you may sell a Ford put at $12 and buy a Ford put at $10. If Ford stock is trading at less than $10 at the expiration date, you lose more money on the put you sold than you make on the put you bought, resulting in maximum possible loss from this strategy. If the price of Ford stock is more than $12, neither option will be exercised and you make money because you must have made more from selling the higher strike put option than you paid to buy the lower strike option. For price levels between $10 and $12, again, you may break even, make or lose money.
Key Differences
With both strategies, the maximum gain as well as loss is limited. Therefore, these strategies represent a smaller risk than simply purchasing the underlying stock. However, there are also key differences: You must put up net cash to initiate the bull call spread, whereas you will have to put up no money upfront, but will end up with net cash when you structure a bull put spread. Hence, the bull put is a better choice if you are facing a cash shortage. Furthermore, the call spread usually has a higher maximum profit and lower maximum loss than the put spread with the same two strike prices. However, the put spread will have a lower break-even point, and will register a profit with less of a gain in the underlying stock's price.
References
Writer Bio
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.