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"Bull Call Spread Question?"


Question By Cloud

"Bull Call Spread Question?"

I just open the bull call spread trade recently. I understand the theory and the profit and risk potential. what I'm confusing is that when calculate the different between strike price and the different between the two options, they are not perfectly related. For example, let says aapl oct09 110 call option is traded at $32.90 and aapl oct09 135 call option is traded at $15.40. eventhough the different in strike price is $25 but the different in the traded option price is only $17.50. I put on this trade with $10 debit. So instead of the potential profit will be 25 - 10 = 15 maxprofit, instead it is 17.5 - 10 = 7.5 real profit. The real profit is 50% off of the potential profit. Is this normal? How would this really works? Or do I need to exercise the right and buy the stock and sell it? Please help me explain Thank you cloud

Asked on 21 June 2009

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Answered by Mr. OppiE

Hi Cloud,

First of all, lets clarify your situation. You bought AAPL Oct 135/110 Bull Call spread at a debit of $10 which is now trading at a debit of $17.50, right? You are wondering why this AAPL Bull Call Spread is not making its maximum profit potential when AAPL is now trading above $135.

The Maximum Profit Potential of a Bull Call Spread is the difference between its strike LESS the net debit. This formula tells you the Maximum Profit that the bull call spread can attain when the stock goes up. In this case, the maximum profit attainable by your bull call spread on AAPL is $135 - $110 - $10 = $15, when AAPL is $135 or higher during October expiration. In this case, your maximum loss is $10 with a maximum profit of $15.

The problem with all options trading spreads is that you need to hold until expiration to reap the full benefit, otherwise, the short leg could gain in extrinsic value due to volatility in the short term and erase your profits. This is what is happening to your bull call spread position on AAPL right now. The $135 strike call options, which still has a long long way to October expiration, still has a lot more extrinsic value in it and with the speculation going on in AAPL right now, these extrinsic value could remain high for a while. In fact, the AAPL Oct $135 Calls quoted in your example still has $11.00 in extrinsic value. In order to reap your full $15 in profit, you need to hold all the way to October expiration and hope that AAPL do not drop below $135 by that time. If AAPL is at $139.48 at expiration, the $110 strike call options will be worth $29.48, the $135 strike call options will be worth $4.48 so $29.48 - $4.48 - $10 = $15, which is your maximum profit potential. See the problem now? The problem is there is now too much extrinsic value on your short leg and too long to go to expiration.




In conclusion, the problem with options trading spreads is that you must be prepared to hold all the way to expiration in order to reap the full benefits. Trying to trade out of a spread halfway like what you are doing now never gets you its full potential profit. If you expect a stock to move quickly, never use a spread with such a long expiration.

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