Options are risky instruments because a small movement in the underlying price translates into a large percentage change in the options’ prices. They are ideal for high-risk traders. But some strategies can be constructed to limit the variation in option prices. Spreads are such strategies.
A bull spread is an options trading strategy which has limited upside in case of an upwards movement in the underlying price. The low reward comes along with lowering of potential downside too. Since the upside of a bull spread is limited, the profit potential from a moderate and a high rise in prices of the underlying security is the same.
- A bull spread can be constructed by buying a call option with a low strike price and selling a call option with a higher strike price. The premium paid for the low strike price call will be higher than the premium received for the higher strike price call, so there will be an initial cash outflow while entering a bull spread with call options. The trader will benefit with an increase in price because the profit from the low strike call will outweigh the loss from the higher strike call.
- A bull spread can also be constructed by buying a put option with a low strike price and selling a put option with a higher strike price. The premium paid for the low strike put will be lower than the premium received for the higher strike put, so there will be an initial cash inflow while entering a bull spread with put options. This behaviour is different from a call bull spread. The trader will benefit by pocketing the net premium received upfront if the price of the underlying rises and both the options expire worthlessly.
Irrespective of how it is constructed, the profit curve from a bull spread looks like below:
Uses: Clearly, a bull spread is a bullish trading strategy where the trader is expecting the market to move up. But he is also risk averse and doesn’t want a large downside exposure. Such a trader may enter a bull spread instead of buying a plane call option or selling a plain put option. The premium paid in case of buying a plain call option is more than that of a bull spread, and the maximum downside if the market moves in the opposite direction is unlimited in case of selling a plain put option. A bull spread provides the perfect balancing act to such a trader.
Options, Futures and Other Derivatives by John C Hull