A Bull Call spread is a hedged risk options strategy that is created by selling an OTM(Out of The Money) call option and buying an ITM (In The Money) call option.
This strategy is useful when you are bullish on the market, so you would want to benefit from a rising market price by selling a Call option of a higher strike than the spot price. However, to hedge against the opposite movement of the market, you could buy a Call option of the lower strike. This would cap your losses to the difference between premiums of lower strike and higher strike.
Risk vs Reward
Let us consider the example of a 10 AUG expiry for NIFTY when the spot is at 19517. We can create a Bull Call spread by selling a call option of 19700 strike trading at 25.4 while buying a call option of 19500 strike trading at 102.55.
This would create a bull call spread with a maximum possible profit of 6142 and a maximum possible loss of 3857.
Max Profit for this strategy would happen when the market is higher than 19700, let us calculate the profit at 19800 at expiry. The profit/loss for any option position is calculated at ( spot – strike – premium ) * lot size.
If the position is short then the amount is negative or loss, while if the position is long then the amount is positive or profit. However this is applicable only when options expire (ITM) In The Money, the profit loss for the OTM (Out of The Money) option always amounts to the premium paid.
Loss on short 19700 CE = ( 19800 – 19700 – 25.4 ) * 50 = 3730 * -1 ( short position)
Profit on long 19500 CE = (19800 – 19500 – 102.55 ) * 50 = 9872
Net maximum profit for strategy = 9872-3730 = 6142
Maximum loss for this strategy would happen when the market is lower than 19500. If the spot price is lower than the short strike, we would get all the premiums. let us calculate loss assuming an expiry spot price of 19300. Both the options are expiring OTM (Out of The Money) so the profit/loss would be equal to the premium paid or received.
Profit for short 19700CE = 25.4 * 50 = 1270
Loss of long 19500CE = -102.55 * 50 = -5127.5
Net maximum loss for strategy = 1270-3858 = -3857.5
The margin required for this strategy is significantly low compared to selling just a naked option. The margin required for this strategy is 24,670. So our max profit ROI would be 6143/24670 = 25% while our max loss ROI would be 3858/24670 = 16%
This would make it nearly 1:1.5 risk-to-reward ratio which is pretty good.
When to use this strategy
This strategy is useful when you are reasonably sure that the market is going to move higher near the expiry. This strategy is also useful when you are starting with your options journey and have relatively lower capital. This strategy also provides hedging benefits there as the losses are always limited, so you would not lose all your capital even if the market goes against your position.
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