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Bullish Spreads: Finding Good Candidates

Bullish Spreads: Finding Good Candidates

Key Points
  • Bullish spreads allow you to swap profit potential for the opportunity to reduce risk.

  • Spreads offer the ability to take a directional position but typically cost less than straight long options, and their maximum potential loss is typically much less than uncovered (naked) options.

  • Options traders employ bullish spreads when they expect a rise in the underlying security in the near term.

  • We'll examine how to select an expiration date and strike prices.
     

Many options traders, when first introduced to spreads, understand the risk/reward characteristics but they often have difficulty deciding what strike prices to use and how wide to make the spreads. In this article, I'll review how to find good bullish spread candidates, including how to pick an appropriate expiration month and strike prices to create your spreads based on your expectations for the underlying security.

Getting started with spreads

Spreads can offer the ability to take a directional position, but the cost is typically less than straight long options, and the maximum potential loss is typically much less than uncovered (naked) options. Vertical spreads involve simultaneously purchasing and selling two options contracts of the same type (put or call) on the same underlying security. In vertical bullish spreads, the two options contracts have the same expiration date, but the option with the lower strike price is purchased and the one with the higher strike price is sold.

The two most basic types of bullish spreads are debit call spreads and credit put spreads. While both are typically bullish, they differ in terms of when and how you can make a profit or sustain a loss.

How bullish are you?

The table below shows how you can structure a bullish spread to match your level of bullishness. For example, if you're extremely bullish, you may want to consider an out-of-the-money (OOTM) debit call spread or an in-the-money (ITM) credit put spread.

Note: Both will generally require a bullish move of extreme magnitude in the underlying stock in order to reach profitability.

In contrast, if you're neutral to only slightly bullish, you may want to consider an ITM debit call spread or an OOTM credit put spread, both of which can sometimes be profitable even with little or no movement in the underlying stock.

As with most options strategies, the greater the underlying move needed, the higher the profit potential—but it's also less likely a profit will be made. Similarly, if you structure your spread so that profitability is possible without movement in the underlying stock, the potential profit will likely be very small.

Bullish spreads to consider

Bullish spreads to consider

Source: Schwab Center for Financial Research.

Our goal is to identify possible bullish spread candidates, so let's review some sample charts using technical analysis. Note: The examples do not include commission charges, which may be significant and will affect the profit or loss.

In the first chart, XYZ stock appears to be bouncing off a technical support line. Therefore, you may be expecting a continued upward move.

XYZ coming off a support line

XYZ coming off a support line

Are you moderately bullish?

If you're only moderately bullish on XYZ stock, you may want to consider the debit call spread in the example below. As with all spreads, you can calculate the maximum gain, maximum loss and breakeven price, before actually entering the trade. The maximum loss on a debit spread will always be the amount of the initial debit.

Debit call spread example:

  • Buy 10 XYZ Nov 50 calls @ $3.35
  • Sell 10 XYZ Nov 55 calls @ $0.45
  • Debit = $2.90
  • Breakeven price = $52.90 (Nov 50 strike price + debit amount)
  • Maximum gain = $2.10 (net of strikes – the debit) ($5.00 – $2.90)
  • Maximum loss = $2.90 (net debit paid)

Total cost of this trade = $2,900 ([debit] x [number of spreads] x [option contract multiplier]) or ($2.90 x 10 x 100)

This XYZ example at $52.76 would be considered at the money (ATM) because the long option is ITM and the short option is OOTM. In addition, the chart above shows these November options on October 5, about five weeks before expiration. By calculating the breakeven before entering the trade, you can see that with a breakeven price of $52.90, XYZ only needs to increase in price by more than $0.14 by expiration to be profitable.

At expiration, the maximum profit of $2,100 will be reached if XYZ is above $55 (the higher strike price) because both options will be exercised and the net between the two is $5,000. Subtract from $5,000 the initial cost of $2,900 to arrive at the net profit. At expiration, losses will be incurred if XYZ closes below $52.90, with the maximum loss of $2,900 occurring at any price below $50 (where both options expire worthless). If that occurs, you'd lose your initial investment.

Are you extremely bullish?

If you are very bullish on XYZ stock, you may want to consider the credit put spread in the following example. Here, you buy a put option and sell a put option with a higher strike price. The maximum gain on a credit spread will always be the amount of the initial credit. In addition, a credit spread has a margin requirement equal to the maximum loss, but the initial credit can be applied against it.

Note: In this example, you would receive a credit when the spread is established, yet you can still calculate the maximum gain, maximum loss and breakeven before the trade is entered.

Credit put spread example:

  • Buy 10 XYZ Nov 55 puts @ $3.00
  • Sell 10 XYZ Nov 60 puts @ $7.60
  • Credit = $4.60
  • Breakeven = $55.40 (Nov 60 strike price – credit amount)
  • Maximum gain = $4.60 (credit received)
  • Maximum loss = $0.40 (net of strikes – the credit)
  • Total margin requirements for this trade = $400 ([net of strikes – the credit] x [number of spreads] x [option contract multiplier]) or ([$60 – $55 – $4.60] x 10 x 100)

This example would be considered ITM because with XYZ at $52.76, both put options are ITM.  Because the chart above is dated October 5, these November options have about five weeks until expiration. By calculating the breakeven before entering the trade, you can see that with a breakeven price of $55.40, XYZ needs to increase considerably in price (by more than $2.64 before expiration) to be profitable.

At expiration, the maximum profit of $4,600 will be reached if XYZ is above $60 (the higher strike price), since both options will expire worthless, and the entire initial credit will be retained.

Also losses at expiration will ensue if XYZ closes below $55.40, with the maximum $400 loss occurring at any price below $55 (where both options are exercised). If that happens, the initial credit will be completely lost. Subtract the initial $4,600 credit from the net loss between the two strike prices of $5,000 to find out the maximum loss, which is $400.

Let's review a second chart using basic technical analysis, illustrating where bullish spreads might also be appropriate. In the chart below, you have identified XYZ stock, which appears to have just broken through an upside resistance line. Therefore, you're expecting a continued upward move.

Bullish spread with upward movement

Bullish spread with upward movement

Are you feeling neutral to slightly bullish?

If you are only neutral to slightly bullish on XYZ stock, you may want to consider the debit call spread from the example below.

Debit call spread example:

  • Buy 10 XYZ Nov 40 calls @ $4.40
  • Sell 10 XYZ Nov 45 calls @ $0.40
  • Debit = $4
  • Breakeven price = $44 (Nov 40 strike price + debit amount)
  • Maximum gain = $1 (net of strikes – the debit) ($5.00 – $4.00)
  • Maximum loss = $4 (net debit paid)
  • Total cost of this trade = $4,000 ([debit] x [number of spreads] x [option contract multiplier]) or ($4 x 10 x 100)

This example with XYZ at $44.21 could be considered ATM or ITM, because the long option is ITM and the short option is just slightly OOTM. In this hypothetical example, the chart above shows these November options on October 5, about five weeks before expiration. By calculating the breakeven before entering the trade, you can see that with a breakeven price of $44, XYZ can actually drop in price by $0.21 (to $44) before expiration, and remain profitable. 

At expiration, the maximum profit of $1,000 will be reached if XYZ is above $45 (the higher strike price), since both options will be exercised, and the net between the two is $5,000. Subtract from $5,000 the initial spread cost of $4,000 to arrive at the net profit. Losses will be incurred if XYZ closes below $44 at expiration, with the maximum loss of $4,000 occurring at any price below $40 (where both options expire worthless). If that occurs, you'd lose your initial investment.

Are you moderately bullish?

If you are moderately bullish on XYZ stock, you may want to consider the following credit put spread example.

Credit put spread example:

  • Buy 10 XYZ Nov 42.50 puts @ $0.30
  • Sell 10 XYZ Nov 47.50 puts @ $3.40
  • Credit = $3.10
  • Breakeven price = $44.40 (Nov 47.50 strike price – the credit)
  • Maximum gain = $3.10 (credit received)
  • Maximum loss = $1.90 (net of strikes – the credit)
  • Total margin requirements of this trade = $1,900 ([net of strikes – the credit] x [number of spreads] x [option contract multiplier]) or ([$47.50 – $42.50 – $3.10] x 10 x 100)

This $44.21 XYZ example would be considered ATM because the long option is OOTM and the short option is ITM. In this example, the chart shows these November options on October 5, about five weeks before expiration. By calculating the breakeven before entering the trade, you can see with a $44.40 breakeven price, XYZ only needs to increase in price by more than $0.19 by expiration to be profitable.

At expiration, the maximum profit of $3,100 will be reached if XYZ is above $47.50 (the higher strike price), since both options will expire worthless, and the entire initial credit will be retained. Losses will be incurred at expiration if XYZ closes below $44.40, with a $1,900 maximum loss occurring at any price below $42.50 (where both options are exercised). If that occurs, the initial credit will be lost. Subtract the $3,100 initial credit from the net between the two strike prices of $5,000 to arrive at the maximum loss of $1,900.

Managing risk with spreads

Spreads can be very versatile, and the possibilities are plentiful. They can be a useful risk management tool, swapping profit potential for the opportunity to reduce risk. Hopefully, these few examples have helped show how to structure both credit and debit spreads to potentially take advantage of charts that you believe are exhibiting signs of varying bullishness.

I hope this enhanced your understanding of bullish spreads. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

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