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Option Strategy Spotlight: ITM Bull Call Spread vs. OTM Bull Call Spread

Once a bullish stock candidate has been identified, option traders need to select an appropriate strategy that matches their price forecast. In this article, we’ll take a closer look at how an in-the-money (ITM) bull call spread stacks up against an out-of-the-money (OTM) bull call spread.     

In the last option strategy spotlight article we compared a long call with a bull call spread strategy and highlighted the respective trade-offs of each strategy. Continuing with this theme I’d like to compare an in-the-money (ITM) bull call spread with an out-of-the-money (OTM) bull call spread. If you are a spread trader you have likely encountered a scenario where you have found a bullish stock candidate and wondered which strike prices are the “best” ones to select. However let me remind you that the purpose of these strategy comparisons is not necessarily to declare a “winner” but to highlight the differences (i.e. trade-offs) with each so that you are better informed when you ultimately make a decision about which strategy is right for you on any given trade.

Strategy overview

In case you aren’t familiar with a bull call spread here is a brief summary of this two-legged strategy:

Bull call spread

Description:

Using the same underlying security, buy a call option and simultaneously sell a higher strike call option with the same expiration, for a net debit.

Maximum Gain

The difference in the strike prices minus the net debit paid.

Maximum Loss

The net debit paid.

Break-Even Price

Lower call strike + net debit paid

Bullish set-up example

As I’ve mentioned in several of my articles, I always find that any topic can be communicated, and potentially understood, better through the use of a detailed example. Therefore, let’s assume that you are bullish on a stock that has been in a steady uptrend and are considering initiating a bull call spread in order to potentially capitalize on your opinion. The chart might look something like this:

Source: StreetSmart Edge®

Let’s assume you are considering establishing either a (1 contract x 1 contract) in-the-money bull call spread, using the 160.00 & 170.00 strikes, or an out-of-the-money bull call spread, using the 170.00 & 180.00 strikes and you are presented with the following quotes in the option chain:

ITM bull call spread

Source: StreetSmart Edge®

OTM Bull Call Spread

Source: StreetSmart Edge®

The prices listed above are actual quotes on an actual stock (though the actual ticker symbol has been replaced by a fictitious “XYZ” ticker) and were taken at the time this article was written to keep the comparisons as “real world” as possible. Using the ask prices for each respective longs strike and the bid prices for each respective short strike we have the following breakdown:

  • Cost: The ITM bull call spread has a cost of $7.40 ($11.00 ask - $3.60 bid) while the OTM bull call spread has a cost of $3.20 ($3.90 - $0.70), therefore the nod goes to the OTM spread in this category. Advantage: OTM Bull Call Spread.
  • Maximum gain: The potential maximum gain of the OTM bull call spread is over 2.5x that of the ITM bull call spread ($6.80 vs. $2.60) so the OTM bull call is the winner in this category as well. Advantage: OTM Bull Call Spread.
  • Maximum loss: The potential maximum loss, which is equal to the net debit paid for each spread, of the OTM bull call spread is less than 50% of the ITM bull call spread ($3.20 vs. $7.40) so the OTM bull call wins once again. Advantage: OTM Bull Call Spread.
  • Probability of making a profit: In case you weren’t aware, you can use the Trade & Probability Calculator in StreetSmart Edge in order to obtain an approximate probability that a stock will be above a certain price at expiration (simply enter the prices in the lower/upper target fields in the “Settings” section of the tool). Entering the respective break-even prices into the tool shows that there is an approximate 62% chance that the ITM spread will close above its break-even price of $167.40 and about a 38% chance that the OTM spread will close above its break-even price of $173.20, so the ITM bull call spread wins this category. Advantage: ITM Bull Call Spread.

Source: StreetSmart Edge®

  • Break-even price: The break-even price, which is calculated by adding the net debit to the long call strike of each spread, of the ITM bull call spread conveys a similar story to that of the probability of making a profit. That is, with XYZ currently trading at $169.78, and a $167.40 break-even price on the ITM bull call spread, you can see that the stock can move sideways or even decline up to $2.37 and you could still end up with a profit on this trade. However, with the OTM bull call spread you need the stock to increase $3.42 by expiration before reaching the break-even price of $173.20, and more if you want to make a profit. Therefore, the ITM spread is the victor of this category. Advantage: ITM Bull Call Spread.
  • Position Theta: Because the short 170.00 strike on the ITM bull call spread has more time value than the long 160.00 strike, the Position Theta actually turns out to be +0.0269. What this means is that time value is working in your favor and the ITM spread will initially gain $0.0269 in value per day due to time decay, assuming all other variables are held constant. Compare this with the OTM bull call spread’s net time decay of -0.0358, which means that time value is working against you and this spread initially stands to lose $0.0358 per day (all things else being equal) and the ITM spread owns this category as well. Advantage: ITM Bull Call Spread.
  • Position Delta: The Position Delta, derived by combining the Deltas of each strike for each spread, of +0.3388 for the ITM spread means that you can expect the value of the ITM spread to initially increase by ~$0.34 if XYZ increases by $1.00 immediately (all other variables held constant). However, when compared to a slightly higher Position Delta of + 0.3514 for the OTM spread and the advantage is slighlty tilted in favor of the latter.  Advantage: OTM Bull Call Spread.

Key takeaways

The comparison between these two spreads helps illustrate the concept of “trade-offs” that exists with option strategies, and even between the strike selection(s) within a given strategy. With an ITM bull call spread you stand to potentially lose more and have less to gain, but time is working in your favor and your probability of achieving a profit of any kind can be significantly higher.

The OTM bull call spread offers more profit potential with less at risk, but you need the stock to move higher, in fairly short order, and are exposed to time decay while you wait for the move to occur. Therefore, the “appropriate” choice likely depends on your conviction level of bullishness along with your personal risk tolerance. I hope this article has helped provide some insight into how strike selections play a significant role in the strategy selection process. Look for additional bullish and bearish strategy comparisons in upcoming Option Strategy Spotlight articles.  

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¹For the sake of simplicity, the examples shown do not take into consideration commission and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of the strategies discussed. Please consult your tax advisor for more information on potential tax implications.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Multiple leg options strategies will involve multiple commissions.  Spread trading must be done in a margin account.  Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any option transaction.

Spread trading must be done in a margin account. 

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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