A bull spread is a largely used strategy in options trading that involves the use of either two puts or two calls with the same underlying asset and expiration date. The goal of this strategy is to benefit from a moderate rise in the price of the underlying asset.
How Bull Spreads Work
Bull spreads are created by purchasing an option at a lower strike price and simultaneously selling another option at a higher strike price. This setup can be constructed using either call options (bull call spread) or put options (bull put spread).
Bull Call Spread
A bull call spread involves:
- Buying a call option with a lower strike price.
- Selling a call option with a higher strike price. Both options share the same underlying security and expiration date.
Bull Put Spread
A bull put spread includes:
- Buying a put option with a higher strike price.
- Selling a put option with a lower strike price. Similar to the bull call spread, both options have the same security and expiration date.
Types of Bull Spreads
Debit Spreads
A bull call spread is considered a debit spread because the strategy requires an initial net outflow of funds (debit) when the call with a lower strike price is bought.
Credit Spreads
Conversely, a bull put spread is a credit spread as it results in a net inflow of funds (credit) since the sold put generally has a higher premium than the bought put.
Example of a Bull Spread
Consider an underlying stock priced at $50. A trader opts for a bull call spread by:
- Buying a call option with a strike price of $45, costing $7.
- Selling a call option with a strike price of $55, receiving $3.
The net cost (debit) of the spread is $4 ($7 paid - $3 received).
For a bull put spread:
- Buying a put option with a strike price of $55, costing $8.
- Selling a put option with a strike price of $45, receiving $11.
The net credit of the spread is $3 ($11 received - $8 paid).
Applications and Special Considerations
Risk and Reward
- Limited Risk: The maximum loss is confined to the net debit paid for a bull call spread and the difference between the strike prices minus the net credit received for a bull put spread.
- Limited Reward: The maximum profit is capped at the difference between the strike prices minus the net debit paid (bull call spread) or the net credit received (bull put spread).
Market Conditions
Bull spreads are best suited for moderately bullish outlooks on the underlying asset, implying the trader expects limited upward movement rather than a significant price increase.
Historical Context and Evolution
Although options trading traces back to ancient times, the modern concept of bull spreads has significantly evolved. The 1973 establishment of the Chicago Board Options Exchange (CBOE) marked a new era for strategic and sophisticated options trading, including the usage of bull spreads.
Comparisons with Other Strategies
Bull Spread vs. Bear Spread
- Bull Spread aims to profit from a moderate price increase.
- Bear Spread is structured to benefit from a moderate price decline, achieved by either put or call options combinations.
Related Terms and Definitions
- Intrinsic Value: The difference between the underlying asset’s current price and the option’s strike price.
- Time Decay: The reduction in an option’s value as it approaches its expiration date.
- Strike Price: The price at which the underlying security can be bought or sold, as defined by the options contract.
- Expiration Date: The date when the options contract expires and can no longer be exercised.
FAQs
What happens if both options expire in the money?
Can a bull spread be adjusted?
References
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy.
Summary
The bull spread is a focused options trading strategy that capitalizes on moderate market upswings. By involving either two puts or two calls, it offers a structured approach with defined risks and rewards, making it an attractive choice for traders with a bullish market outlook.
