A bull spread consists of a buy leg and a sell leg of different strikes for the same expiration and same underlying contract.
This strategy will pay off in a rising market, also known as a bull market, that is why it is referred to as a bull spread.
Bull spreads can be constructed from either going long a call spread or going short a put spread.
A trader believes that the market will have a moderate rise before the options expire.
If the underlying market was trading at 100, he would buy a 105 call for $3 and sell the 110 call for $2. By selling the 110 call, he receives a premium, which offsets the cost of the 105 leg. The total cost of the spread is $1. The breakeven point for the spread is 106. This is the cost of the spread plus the 105 strike.
The best-case scenario is if the market finishes at or above 110 because the 105-110 call spread will pay off $5. This is the maximum payoff for the spread, regardless of where the underlying finishes. If we subtract the $1 cost of the spread, the total profit for the trade will be $4.
Assume the underlying finished at 113. The 105 call will pay the trader $8, but he will need to payout $3 on the 110 call. Another example, if the market finishes at 130, the 105 call will pay the trader $25, but he will need to payout $20 on the 110 call.
The worst-case scenario is if the market finishes at or below 105. Because both the 105 and 110 call expire out-of-the-money and are therefore worthless. The trader loses the full cost of the spread, $1.
If the trader had purchased only the 105 call at $3, his loss would be $3 versus $1.
If the underlying finishes at 107.5, the long 105 call will be worth $2.50 and the short 110 call expires worthless. The trader’s payout of $2.50 minus the $1 cost of the spread gives him $1.50 profit.
If the trader had bought only the 105 call, his payout would still be $2.50, but that is less than the $3 he would have paid for the 105 call alone.
Bull spreads can also be constructed from selling a put spread.
Selling a put allows you to collect a premium that you can keep if the underlying futures contract finishes at or above the strike price.
Instead of buying the 105-110 call spread, we can sell the 110-105 put spread. This would entail selling the 110 puts and buying the 105 puts which would result in a $4 credit with the underlying future trading at 100
The breakeven point for the spread is 106, the 110 strike minus the spread credit of $4. This is the same breakeven point as the call bull spread.
If the market finishes above 110, the puts expire worthless. Therefore, the trader keeps the $4 he received by selling the put.
If the market finishes at 103, the 110 put is worth $7 and the 105 put is worth $2. Therefore, the put spread is worth $5 dollars. The trader received $4, and must now payout $5, resulting in a $1 loss.
If the market finishes at 107.5, the 110 put is worth $2.50 and the 105 put expires worthless. The trader must pay out $2.50 from his $4 credit. Resulting in a $1.50 profit.
We can see in this chart, that these three scenarios have the same outcome whether we buy a call spread or sell a put spread to create a bullish position. Traders still want the market to finish above the high strike of the spread.
Bull spreads are a commonly used and valuable options strategy.