Bull Credit Spread Explained

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Bull Credit Spread

In options trading, a bull credit spread refers to any credit spread in which the value of the spread position decreases as the price of the underlying security rises. The simplest way to construct a bull credit spread is via puts. See bull put spread.

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Bull Spread

What Is a Bull Spread?

A bull spread is an optimistic options strategy designed to profit from a moderate rise in the price of a security or asset. A variety of vertical spread, it involves the simultaneous purchase and sale of either call options or put options with different strike prices but with the same underlying asset and expiration date. Whether a put or a call, the option with the lower strike price is bought and the one with the higher strike price is sold.

A bull call spread is also called a debit call spread because the trade generates a net debt to the account when it is opened. The option purchased costs more than the option sold.

The Basics of a Bull Spread

If the strategy uses call options, it is called a bull call spread. If it uses put options, it is called a bull put spread. The practical difference between the two lies in the timing of the cash flows. For the bull call spread, you pay upfront and seek profit later when it expires. For the bull put spread, you collect money up front and seek to hold on to as much of it as possible when it expires.

Both strategies involve collecting a premium on the sale of the options, so the initial cash investment is less than it would be by purchasing options alone.

Key Takeaways

  • A bull spread is an optimistic options strategy used when the investor expects a moderate rise in the price of the underlying asset.
  • Bull spreads come in two types: bull call spreads, which use call options, and bull put spreads, which use put options.
  • Bull spreads involve simultaneously buying and selling options with the same expiration date on the same asset, but at different strike prices.
  • Bull spreads achieve maximum profit if the underlying asset closes at or above the higher strike price.

How the Bull Call Spread Works

Since a bull call spread involves writing a call option for a higher strike price than that of the current market in long calls, the trade typically requires an initial cash outlay. The investor simultaneously sells a call option, aka a short call, with the same expiration date; in so doing, he gets a premium, which offsets the cost of the first, long call he wrote to some extent.

The maximum profit in this strategy is the difference between the strike prices of the long and short options less the net cost of the options—in other words, the debt. The maximum loss is only limited to the net premium (debit) paid for the options.

A bull call spread’s profit increases as the underlying security’s price increases up to the strike price of the short call option. Thereafter, the profit remains stagnant if the underlying security’s price increases beyond the short call’s strike price. Conversely, the position would have losses as the underlying security’s price falls, but the losses remain stagnant if the underlying security’s price falls below the long call option’s strike price.

How the Bull Put Spread Works

A bull put spread is also called a credit put spread because the trade generates a net credit to the account when it is opened. The option purchased costs less than the option sold.

Since a bull put spread involves writing a put option that has a higher strike price than that of the long call options, the trade typically generates a credit at the start. The investor pays a premium for buying the put option but also gets paid a premium for selling a put option at a higher strike price than that of the one he purchased.

The maximum profit using this strategy is equal to the difference between the amount received from the sold put and the amount paid for the purchased put – the credit between the two, in effect. The maximum loss a trader can incur when using this strategy is equal to the difference between the strike prices minus the net credit received.

Benefits and Disadvantages of Bull Spreads

Bull spreads are not suited for every market condition. They work best in markets where the underlying asset is rising moderately and not making large price jumps.

As mentioned above, the bull call limits its maximum loss to the net premium (debit) paid for the options. The bull call also caps profits up to the strike price of the option.

The bull put, on the other hand, limits profits to the difference between what the trader paid for the two puts—one sold and one bought. Losses are capped at the difference between strike prices less the total credit received at the creation of the put spread.

By simultaneously selling and buying options of the same asset and expiration but with different strike prices the trader can reduce the cost of writing the option.

When Should I Close Credit Spread Trades?

You can get stock tips from your neighbor, your dentist, even your cab driver! But can any of these people tell you when to sell your investments? Knowing when to exit a position is every bit as important as understanding what to invest in. And today, we’re going to talk about when (and how) to close credit spread trades.

Editor’s Note: This is part five of a multi-part series on credit option spreads. See also:

Stay tuned for more great credit spread content to come!

Three Reasons To Close Credit Spread Trades

When you invest in shares of a stock, you’re immediately met with a new challenge: Under what circumstances should you sell your investment? Should you lock in profits if the stock trades higher? Should you cut your losses if it trades lower? This is a grey area that many investors — even professional investors — never master.

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I like the fact that credit spreads always have a limited time frame. At some point, the trade will disappear from my account. This is because the option contracts have a limited time horizon.

Most of the time, I allow my credit spread trades to expire. My winning trades capture the maximum expected gain when the underlying stock moves in my favor. And if the stock moves against me, My trade will typically be closed out for a limited loss.

But occasionally, I do close out my spread trades early. There are basically three potential reasons for this:

  1. I may close credit spread trades to lock in profits.
  2. I may close credit spread trades to reduce potential loss.
  3. I may close credit spread trades to avoid a stock position.

Let’s take a closer look at each of these scenarios.

When to Close Credit Spread Trades For Profits

You set up a credit spread trade, and everything worked out the way you planned. Hooraaaayyy!!

You could wait for your option contracts to expire. And in many cases, this is the best option. Why pay your broker a commission to close out a trade. After all, when your option contracts expire, you’ll realize the maximum profit and the trade will be complete.

Still, there are two reasons you might want to go ahead and close your trade:

1) Opportunity Cost

When you set up a spread trade, a certain amount of cash in your account is set aside. This is to cover the risk of the trade moving against you. That cash could be used for other opportunities.

So in some cases, it makes sense to close out a credit spread trade at a profit, just to free up that cash for another opportunity.

2) Managing Risk

Often when a stock moves in your favor, you wind up with the following scenario:

You have the opportunity to close your trade and book 90% of your expected profit. And your risk is giving up all of this profit, and potentially accepting a loss if the stock reverses.

In this case, the risk of losing your profit may far exceed the incremental profit you stand to gain from letting your position expire. So in this scenario, it often makes perfect sense to pay a small commission to go ahead and close your spread trade.

Keep in mind, when you close credit spread trades early, you won’t be realizing the maximum possible profit. But you’ll still be capturing most of the profit you were expecting.

And if you close your trade early, you’ll free up cash for other opportunities, and eliminate the risk of giving this profit back.

When to Close Credit Spread Trades For a Loss

Not every trade will work out as planned. That’s just the way investing works.

One of the beauties of credit spread trades is that your potential loss is limited. No matter how far the underlying stock moves against you, you won’t lose more than your planned amount.

Still, sometimes it makes sense to close credit spread trades early.

Think about this decision from a statistical perspective…

If your stock has moved against you, you may be down $150 per contract. Your maximum loss for the trade may be $200 per contract. So if you allow the trade to expire, you’ll lose an additional $50 per contract.

Now, what is the statistical probability that the stock will reverse? How much would you gain if the stock traded higher?

Let’s say you estimate there is a 10% chance that your trade will reverse. In this case, you expect to make back your $150 decline and actually book a $150 gain. So your position would improve by a total of $300.

Of course, the other side of this coin states that there is a 90% chance you will lose $50 if you stay in the trade.

in this case, you’re better off statistically to close the trade and forego the potential profits if the stock reverses. You would never risk $50 to have a 10% chance of making $300. That scenario would lose money over the long-run.

Statistically speaking, you should close credit spread trades for a loss if you can take a smaller loss than planned. But only if your probability of a rebound is very small.

When to Close Credit Spread Trades to Avoid a Position

If you enter a credit spread trade and the stock closes between your two strike prices, you’ll be required to buy or sell shares of stock at the higher strike price.

This is because you sold an option contract that is ultimately exercised. (However you will not exercise the put you bought. That’s because the other contract is set to expire “out-of-the-money.”)

If you do not want to take a position in the stock, then you must close out the “in-the-money” contract that you sold when entering the spread trade.

For bull put spreads, you must buy back the put contract with a higher strike price that you sold. For bear call spreads, you must buy back the call contract with a lower strike price.

This way, you won’t buy or sell shares of stock.

You could either take a gain or a loss when you close spread trades this way. In almost every case, the loss will be less than your maximum expected loss (from when you set up the trade). Or your gain will be less than the maximum expected profit (from when you set up the trade).

As a general rule, I like to allow my credit spread trades to expire naturally. That way I don’t have to pay commission costs to close out these trades. But as you can see, sometimes it makes sense to proactively close these trades and move on to the next opportunity.

Next, we’ll talk about the practical side of executing a spread trade. So be on the lookout for the next credit spread trade article!

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