CHAPTER 8

Bullish Strategies

Bullish strategies in options trading are used when the investor expects the underlying asset price to move upwards. It is necessary to assess how high the asset price can go and the time frame in which the rally will occur in order to select the optimal trading strategy.

The most bullish strategies are the simplest ones where the investor executes a plain vanilla call option. These strategies are the ones that you would probably try out as a newbie options trader. However, call options have a limited life span. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthless.

Assume that it is May and you believe that the price (currently $160) of ABC shares will appreciate over the next months. To take advantage of this you decide to buy one lot (100 call option contracts) at the money and at the price of $2.02 each with an expiration in July. The price is the premium paid. You have effectively bought the right but not the obligation to buy 100 ABC shares before or on the 18th July. For this right you have paid a premium of just $202 instead of paying $16,000 for the 100 shares. If the price of ABC shares on the 18th July is $152 (out of the money) you let the option expire worthless and your loss is the premium paid. However, if before or on the 18th July the price of ABC shares has increased in value to say $170 per share (in the money), you could exercise the option at the strike price of $160 per share giving you a profit of 100 × ($170 − $160) = $1,000 less the premium you paid of $202, leaving you with a profit of $798 on the trade.

Table 8.1 is an example of an option strategy exercised in the money on or before the expiration date (Figure 8.1).

Table 8.1 ABC stock option trade exercised (in the money)

Figure 8.1 ABC stock long call strategy

Table 8.2 ABC stock option trade (out of the money)

Table 8.2 provides an example of the same option strategy expiring out of the money with just the loss of the premium to the option holder.

The strategy in this example is a purchase of call options. But what if you were a writer of an option and not the purchaser? As a writer who was bullish on ABC stock, your strategy would be to sell a put and receive the premium. You would be hoping that the put option would be allowed to expire worthless by the buyer of the put because the stock price was out of the money at the expiration date and had risen to a level above the break-even price. Thus you could pocket the premium and that would be your profit. However, your risk would be that the stock price falls and is exercised in the money leaving you with a bigger loss than the premium you collected.

Table 8.3 Option strategy

As we mentioned earlier in this book, it is worth bearing in mind that there are four positions that you can take depending on your options strategy and whether you are bullish or bearish on a particular asset (Table 8.3).

The long call strategy is the most bullish but riskiest of all the bullish strategies and should only be used when all technical and fundamental indicators are indicating that the underlying asset is on the rise. This strategy can also be used for stock index and currency options equally as well.

A more conservative or moderate bullish strategy is the bull call spread option which is used when the investor believes that the price of the underlying asset will increase moderately in the short term.

Bull Call Spread Strategy

Bull call spreads can be executed by buying an at the money call option (long call) while at the same time writing (short call) a higher striking out of the money call option of the same underlying security and the same expiration month. By shorting the out of the money call option you would reduce the cost of establishing the bullish position. On the other hand you would forgo the chance of making a large profit if the underlying asset price rises steeply (Figure 8.2).

Maximum profit is gained for the bull call spread options strategy when the stock price moves above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial net premium given to enter the position.

The formula for working out the maximum profit is:

Figure 8.2 XYZ stock bull call spread strategy

The bull call spread strategy will culminate in a loss if the stock price declines at expiration. However, the maximum loss cannot be more than the initial net premium given to enter the spread position.

The formula for achieving maximum loss is:

Let’s look at a practical example. It is June and you believe that XYZ stock, which is trading at $35, is going to rally soon and you enter a bull call spread by buying a July 33 call for $4 and writing a July 38 call for $1. The net investment required to put on the bull spread is a net premium given of $3.

The stock price of XYZ begins to rise and closes at $39 on expiration date. Both options expire in the money with the July 33 call having a value of $2 ($6 increase in stock price − $4 cost of long call) and the July 38 call having a value of $0 (premium received − $1 increase in stock price). This means that the option spread is now worth $3 at expiration.

If the price of XYZ had declined to 30 instead, both options would expire worthless. You would lose your entire investment of $3 per share, which is also your maximum possible loss.

Table 8.4 shows the profit and loss profile for a bull call spread for a range of expiry prices. In particular it shows maximum possible profit and maximum possible loss for a long call strike price of 33 and a short call strike price of 38. Remember that 1 option stock contract is 100 shares, therefore the numbers in Table 8.4 should be multiplied by 100 to calculate actual profit or loss of the bull call spread. This strategy can also be used for stock index and currency options equally as well.

Table 8.4 XYZ stock bull call spread profit and loss

Bull Put Spread Strategy

The bull put spread option trading strategy is used when the options trader believes that the price of the underlying asset will move up moderately in the short term. The bull put spread options strategy is also known as the bull put credit spread as the difference between the premium paid and the premium received is credit balance when executing the trade. Bull put spreads are executed by selling (writing) a higher strike price in the money put option and buying a lower strike price out of the money put option on the same underlying stock with exactly the same expiration date.

Both options will expire worthless if the stock price closes above the higher strike price on expiration date and the bull put spread option strategy earns the maximum profit, which is equal to the net premium received when entering the position.

The formula for calculating maximum profit is:

If the stock price falls below the lower strike price on expiration date, then the bull put spread strategy suffers a maximum loss equal to the difference between the strike prices of the two puts minus the net premium received when executing on the trade.

The formula for calculating maximum loss is:

The underlying price at which break-even is realized for the bull put spread position is calculated by means of the following formula.

Let’s look at a practical example of opening a bull put spread position. Assume it is March and you believe that XYZ stock trading at $39 is going to rally in the near term and you decide to enter a bull put spread by buying a May 36 put for $1 and writing (selling) a May 45 put for $3. You receive the difference between the premium paid and the premium received of $2 when you enter the bull put position.

The stock price of XYZ begins to rise and closes at $42 on expiration date. Both options expire worthless and you keep the entire premium credit of $2. This is the maximum profit possible.

If the price of XYZ had fallen to $34 instead, both the May 36 long put and the May 45 short put would expire in the money and have a value of $1 and ($8), respectively. This means that the spread is now worth ($7) on expiration. This is your maximum possible loss for this bull put spread.

Table 8.5 shows the profit and loss profile for a bull put spread for a range of expiry prices. In particular it shows maximum possible profit and maximum possible loss for a long put strike price of 36 and a short put strike price of 45. Recall that 1 option stock contract is 100 shares, therefore the numbers in Table 8.5 should be multiplied by 100 to calculate actual profit or loss of the bull put spread (Figure 8.3).

This strategy can also be used for stock index and currency options equally as well.

Table 8.5 XYZ stock bull put spread profit and loss

Figure 8.3 XYZ stock bull put spread strategy