Q&A

Are "Bullish Call Spreads" Less Risky Than "Buy Stocks"?

Wednesday, September 27, 2006, 8:16 AM ET

Q. Are "Bullish Call Spreads" Less Risky Than "Buy Stocks"?
A. Yes. The ‘bullish spread’ strategies have a clear advantage over the ‘buy stock ’strategy in terms of profit potential. A call bull spread is always a debit transaction, since a call with a lower striking price must always trade for more than a call with a higher price, if both have the same expiration date. Let's consider the following example...

The bull spread is one of the most popular forms of spreading. In this type of spread you buy a call at a certain striking price and sell a call at a higher striking price. Generally, both options have the same expiration date. This is a vertical spread. A bull spread tends to be profitable if the underlying stock moves up in price - hence it is a bullish position. The spread has both limited profit potential and limited risk. Although both can be substantial percentage-wise, the risk can never exceed the net investment. In fact, a bull spread requires a smaller dollar investment and therefore has a smaller maximum dollar loss potential than does an outright call purchase of a similar call. A call bull spread is always a debit transaction, since a call with a lower striking price must always trade for more than a call with a higher price, if both have the same expiration date. Let's consider the following example:

Figure: Bullish Call Spreads Vs. Stock Buying Example

As illustrated below, the ‘bullish spread’ strategies have a clear advantage over the ‘buy stock’ strategy in terms of profit potential. Depending on the strike (the more ’bullish’ the strategy, the larger its maximum profitability), “bullish spread’ strategies can be several times more profitable that a simple ‘buy stock’ strategy. The special feature of a ‘bullish spread’ strategy is its sensitivity around the breakeven point. Slight changes in the stock price around the break-even point cause significant changes in the profitability of ‘bullish spread’ strategies. The more bullish your strategy is, the more sensitive it is around the break-even point.

Figure: Bullish Call Spreads Vs. Stock Buying Example – Profit Potential