Bull Spreads and Bear Spreads

Bull Spreads and Bear Spreads require a directional trading outlook. On an Option Bull Spread you will make a profit only if the stock price rises. On an Option Bear Spread you will make a profit only if the stock falls.

The returns on this strategy can be spectacular if you get the direction and timing right. The bought leg gives you leverage and the sold leg reduces cost and increases your leverage further but at the expense of capping the upside on profits.

Bull Spreads

Description (Source: The Options Industry Council)

A bull call spread is a type of vertical spread. It contains two calls with the same expiration but different strikes. The strike price of the short call is higher than the strike of the long call, which means this strategy will always require an initial outlay (debit). The short call's main purpose is to help pay for the long call's upfront cost.

Construction – Long one call while simultaneously short one call with a higher strike in the same month. Or, short one put while simultaneously long one put with a lower strike in the same month.

Function – Low cost stock directional play which allows you two choices to put on the same trade. Long Vertical Call Spread or Short Vertical Put Spread.

Bias – Bullish

When to use – Use when you feel the stock is likely to rise but not too quickly nor explosively as this strategy has a limited profit potential. Also, when constructed properly, this spread can be used as a premium collection strategy.

Profit Scenario – If stock rises, profit will be defined by the increase in value of the long vertical call spread or, in the case of a short vertical put spread, its decrease in value.

Loss Scenario – If stock declines, loss will be defined by the decrease in value of the long vertical call spread, or in the case of a short vertical put call spread, its increase in value.

Key Concepts – The maximum value of a vertical spread will be equal to the difference between the two strikes, therefore both the buyer and the seller will have a limited profit and limited loss scenario. Depending on which strikes you use, time decay can help or hurt the position. Thus, some vertical spreads can make money over time even if stock stays stagnant.

Bull Call Spread Example (Source: Investopedia.com)

Assume a stock is trading at $18 and an investor has purchased one call option with a strike price of $20 and sold one call option with a strike price of $25 for a total price of $250. Since the investor wrote a call option with a strike price of $25, if the price of the stock jumps up to $35, the investor is obligated to provide 100 shares to the buyer of the short call at $25. This is where the purchased call option allows the trader to buy the shares at $20 and sell them for $25, rather than buying the shares at the market price of $35 and selling them for a loss. The maximum gain is equivalent to $250, or ($25 - $20) * 100 - $250, less any trading costs.

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Bear Spread

Description:

A Bear Spread is an Options strategy that can be used if you are expecting a decline in the price of an underlying asset. 

Construction – Long one call while simultaneously short one call with a lower strike in the same month. Or, short one put while simultaneously long one put with a higher strike in the same month.

Function – Low cost stock directional play which allows you two choices to put on the same trade. Short Vertical Call Spread or Long Vertical Put Spread.

Bias – Bearish

When to use – Use when you feel the stock is likely to decline but not too quickly nor explosively as this strategy has a limited profit potential. Also, when constructed properly, this spread can be used as a premium collection strategy.

Profit Scenario – If stock declines, profit will be defined by the decrease in value of the short vertical call spread or, in the case of a long vertical put spread, its increase in value.

Loss Scenario – If the stock rises, loss will be defined by the increase in value of the short vertical call spread, or, in the case of a long vertical put spread, its decrease in value.

Key Concepts – The maximum value of a vertical spread will be equal to the difference between the two strikes, therefore both the buyer and the seller will have a limited profit and limited loss scenario. Depending on which strikes you use, time decay can help or hurt the position. Thus, some vertical spreads can make money over time even if stock stays stagnant.

Bear Call Spread Example (Source: Investopedia.com)

For example, let's assume that a stock is trading at $30. An option investor has purchased one call option with a strike price of $35 for a premium of $0.50 and sold one call option with a strike price of $30 for a premium of $2.50. If the price of the underlying asset closes below $30 upon expiration, then the investor collects $200 (($2.50 - $0.50) * 100 shares/contract).