The spread is one of the most common option combinations. Spreads can be bullish or bearish. When you understand the most basic setup, in this case a bull call spread, every other spread should be a piece of cake.
A bull call spread is a combination of buying a call option (a long call, also referred to as the "long leg" in the combination) and writing a second call option (a short call, also referred to as the "short leg" in the combination) that has a higher strike price. A spread can limit your risk, but it also limits your gain to the difference between the strike prices of the two options. You can easily structure your spread to be narrow or wide:
Narrow spread: In a narrow bull call spread, the call you write will generate more premium income, but it will greatly reduce your potential gain.
Wide spread: In a very wide spread, you have the potential for a greater gain, but the income you receive from the premium of the call you wrote is very little.
Calculate the cost and the potential gain and then go for spreads that have a gain potential of 3-to-1 or better. In other words, if a spread costs $100, make sure your potential gain exceeds $300 to make it worthwhile. Think of the timing of the spread, too. To get in at a good price (especially for the primary leg, the long call), put in your order when the stock's price is stable or down a little.
Suppose you're bullish on UpMove Corporation (UMC), but you aren't willing to be too aggressive. With UMC's share price at $48 per share, you decide to do a bull call spread. The table breaks down the legs in this scenario.
| The Legs | Strike Price | Cost/Price | Expiration |
|---|---|---|---|
| Long call | $50 | Pay $250 | Dec. 15, 2017 |
| Short call | $60 | Receive $150 | Dec. 15, 2017 |
| Total cost: $100 |
Most options typically expire on the third Friday of the expiration month, especially options on the Chicago Board Options Exchange (CBOE).
As you can see, the bull call spread has two call options that have different strike prices:
The primary leg is the long call at $50, which is closer to the stock's market price of $48, so it's almost at the money; it's a very close out-of-the-money call.
The short call (the one you wrote) is much further away at $60, so it's definitely out of the money. The short call's purpose is to both hedge the position and also help pay for the combination.
The total out-of-pocket cost is only $100, which means you may lose $100 in the worst case (if both options expire). Because the net of this combination is a cost (the $100), you have a net debit spread. So far, so good! Both legs have the same expiration date, so this bull call spread is vertical rather than diagonal.