By Mike Parnos

When you hear the words "bull" and "call," what do you think? It depends on whether you live on a farm or if you trade options. If you live on a farm AND trade options, it can probably get pretty confusing. The best advice I can give you is to be careful where you walk -- although uneducated option traders have been known to step in it on a regular basis.

Here are some trades I don’t use often, but we should know about them and have them in our trading arsenal -- just in case.

The Bull Call Spread

Today, we're going to examine a strategy called a "Bull-Call Spread." No, it's not a new sandwich spread. It's a strategy involving two options, in close proximity, working together to limit risk and position one for profitability.

Bull Call Basics

The word "bull" means you have a bullish outlook. The word "call" simply means we're going to be using calls to establish the position. A Bull Call Spread consists of the purchase of a call and the sale of another call at a higher strike price, both with the same expiration month.

I want to emphasize that the example used subsequently is just that, and only that, an example. I picked IMCL because the numbers happen to provide a good demonstration of how bull call spreads work -- and because it's Martha Stewart's favorite.

There are a few different theories about the placement of bull call spreads. First, let's examine the more bullish scenario.

Example 1

IMCL is trading at $41.98. We've done our research due diligence and believe IMCL stock will appreciate approximately 15 percent in the next few months. How do we take advantage of this prognostication?

We don't have a large trading account. Maybe we're being frugal (or cheap), but it's good money management skills that will keep us in the game. Can we find a blue-light special that will enable us to participate in IMCL's projected move up? Where there's an option, there's a way!

What Have We Done?

We purchased the right to buy $100 shares of IMCL at $45. Then, to reduce our costs, we sold the $50 call, obligating us to sell 100 shares at $50. That's fine because our research tells us that IMCL will probably not go much higher than $50. If we thought IMCL had the potential to go much higher, we wouldn't have sold the $50 call.

So, our investment of $120 enables us to control 100 shares of IMCL (a $4,200 value) for two months. We've positioned ourselves to make nice money if IMCL moves up and, most of all, we've defined our risk.

Positives and Negatives

In the previously described scenario, the amount of potential profit is $380. That is calculated by taking the difference between the strike prices -- $5.00 ($45 - $50) and subtracting the cost of putting on the trade ($120).

On the positive side of the ledger is the fact that our risk reward ratio is 1:3. We're risking $120 with the potential to make $380. Potentially, that's a return of 316 percent. Also, our risk is defined. The very most we could lose on the trade is $120 -- even if IMCL goes to zero. We won't need sleeping pills to rest easy about this trade.

On the negative side of the ledger is the fact that our profit potential is capped. When we sold the $45 call, we limited the amount we can make on the trade to $380. That's the price we pay for being frugal. It's a business decision. Also on the negative side is that IMCL is going to have to make a substantial move up (10%+) before we participate in any profits.

Show Me the Money!

When do the profits begin? First, we have to determine our breakeven point: $46.20. This is calculated by taking the strike price of the long call ($45) and adding the cost of the trade ($1.20). Easy enough.

When Do You Exit?

The options in a bull call spread will achieve their maximum value at expiration. For the first weeks of the trade, even if IMCL moves, the value of the spread will only participate to a point. That's why, if the opportunity presents itself, it's a good idea to exit the trade if you can take 75 percent of the profit. It doesn't make sense to hold on, risking 75% while you waiting for the last 25%.

If IMCL goes the wrong direction, you should have a predetermined exit point. You will need to sell your long call and will have to buy back the short call. With only $1.20 invested in the trade, you can be patient. However, let me reiterate that good money management skills are essential.

Example 2

In Example 1, IMCL would have to move in a particular direction for us to be profitable. Many traders, who aren't good at picking a direction (like me!), look for ways to construct a more neutral scenario that improves one's chance of success. We can use a bull call spread by adjusting the strike prices.

IMCL trading at $41.98
Buy 1 contract IMCL April $35 call for $8.10
Sell 1 contract IMCL April $40 call for $4.40
Total debit: $3.70

What's the Difference?

The most important difference is in what is (or isn't) required of the stock. To collect the maximum profit, IMCL will have to finish above $40. With IMCL trading at $41.98, it's already over $40. Both the long and short calls are already in the money. The percentages of success have increased dramatically. IMCL can move up, stay the same, or even move down $1.98, and we'd still make our maximum profit. The outlook for IMCL only needs to be neutral to be bullish, and we still have a bit of a cushion if we're wrong.

The tradeoff is in the amount of risk and the amount of profit. The risk has increased to $3.70, and the amount of profit has been reduced to $1.30. Is it worth the added risk to make a smaller reward?

Calculating the Return

Is $1.30 a good profit? Get out your abacus and divide the risk ($3.70) into the profit ($1.30). $1.30 is a 35 ($6,250). Our profit (safety) range is $138.75 to $151.25. These are also our bailout points. The closer BBH finishes to $145, the more money we will make.

*This article is reprinted with permission (and modifications) from www.optioninvestor.com.

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