The Bull Call Debit Spread Explained

incomesignals | November 7, 2021

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A bull call spread is a vertical spread that relies on two calls with the different strike prices and same expiration date.

The strike price of the short call is higher than the strike price of the long call, which means this strategy is a debit spread, but the short call option can be utilized to offset some of the cost for the more expensive call that was purchased.

The main difference between buying a straight call option in comparison to initiating a debit call spread is the limited upside profit potential that the spread provides, in return for less risk upfront.

Up to a certain price, the bull call spread works similarly to its long call component would as a standalone strategy.

However, the upside potential is limited to the lower strike price that was sold to bring in additional premium.

That’s the main trade-off; the short call premium reduces the overall cost of the strategy but also sets a ceiling on the profit potential of the trade.

The maximum loss when utilizing the debit call spread is limited to the cost of the spread; in the worst case scenario, the asset will expire at a price that’s below the strike price of the lower prices strike price, the option that was purchased, in that case both options would expire worthless.

The best case scenario would be for the price of the asset to expire at or immediately the strike price that was sold, this way the option that was purchased would expire in the money, while the option that was sold would expire at the money or slightly out of the money, either scenario would yield no profit on the short position, while maximizing gains on the more expensive call that was purchased.

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Break-even = long call strike + net debit paid

This strategy breaks even at expiration if the asset’s price is above the lower strike by the amount of the initial cost of the spread. In that case, the short call would expire worthless and the long call’s intrinsic value would equal the debit.

Time is not in favor of the buyer when it comes to debit spreads and the credit bull spread is no exception and hurts the position, though not as much as it does a plain long call position. Since the strategy involves being long one call and short another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.

Assignment Risk With Stocks

If you trade stock options, you run the risk of early assignment, while possible at any time, it generally occurs only when the stock is very close to expiration and is trading in the money, otherwise the risk of early assignment is relatively low.

Decrease your risk of early assignment by offsetting positions before they get too close to expiration or the strike price of the option that you sold begins trading in the money.

When to Utilize Call Debit Bull Spreads

Because the upside profit potential is capped to the difference between the strike price that was purchased and sold, the best time to initiate a call debit bull spread, is when you are expecting a mild to moderate price gain in the underlying asset.

If you are expecting a major momentum price move, within relatively short time, it makes more sense to purchase a net long call option; to leverage the maximum gain or profit potential of the underlying asset.

But unless you trading stocks during earnings season, it’s very hard to anticipate with any degree of certainty, the degree of the projected price move in the underlying asset and because stocks trend only about 20% to 30% of the time on average, it makes more sense to initiate debit spreads, instead of net long positions the great majority of the time.

When initiating and liquidating the call debit bull spread, it’s always best to place the order as a spread instead of “legging” into the spread one position at time.

My advice is to utilize limit orders and adjust your bid every 30 minutes throughout the day till you get a price fill.

When you trade both sides of the spread as one order, you will find that your trade fills are generally better about 75% of the time.

Lastly, make sure to trade options that are based on assets with high liquidity levels.

Option liquidity always substantially lower than the underlying asset; you will find that liquidity levels can be surprisingly low, which can lead to very wide spreads between the bid and offer; that could lead to less than fair price fills.

So consider trading options that are based on underlying stocks that have higher than average daily average volume, over the past few months, to ensure that your price fill when initiating and liquidating the spread is fair.