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Bull Call Spread: 5 Reasons to Trade this Options Strategy

ChAI
Published by ChAI
May 9 2024
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Bull Call Spread: 5 Reasons to Trade this Options Strategy

Call Options

Before we explain what a Bull Call Spread is, it’s useful to briefly recap on what a call option is. A call option, from the perspective of someone managing raw material price risk, is a financial instrument that provides the right, but not the obligation, to purchase a specific quantity of a raw material or commodity at a predetermined price (strike price) within a specific time period (expiration date).

By purchasing call options on the raw materials they need, companies can effectively set a ceiling on the price they will pay for those inputs over the option's lifetime. This helps them hedge against potential price increases that could erode their profit margins.

Call options, when used on their own with no other derivatives / opposing options as described below, are referred to as being “naked”.

What is a Bull Call Spread?

This isn’t a method for margarine investors to butter up the market.

A bull call spread is an options trading strategy composed of call options, that can be used by companies or traders to manage the risk of rising prices for raw materials or commodities they need to purchase.

Here's how it works from that perspective:

  • The company buys a call option at a lower strike price on the raw material or commodity, giving them the right to purchase it at that price before expiration. This protects them if prices rise significantly above that strike price. This is referred to as the Long Call part of the strategy.
  • At the same time, they sell a call option at a higher strike price on the same raw material with the same expiration date. The premium received from selling this higher strike call option offsets some of the cost of buying the lower strike call. This is referred to as the Short Call.

Why is this an Effective Strategy?

When managing commodity price risk, a bull call spread can be an effective options strategy for the following reasons:

  1. Capped Upfront Costs: Compared to simply buying a call option outright, a bull call spread requires less upfront premium paid since the premium received from the short call offsets some of the cost of the long call. This limits the maximum potential loss to the net debit paid, making it more affordable to establish the position.
  2. Defined Risk Exposure: The maximum possible loss on a bull call spread is strictly limited to the net premium paid. This allows commodity producers, consumers, or traders to precisely define their risk exposure when looking to benefit from a moderate price increase.
  3. Leveraged Upside Participation: While the maximum profit is capped, a bull call spread still provides leveraged upside exposure if the commodity price rises above the long call strike. This allows participants to benefit from a bullish move with less capital outlay.
  4. Higher Probability of Profit: Compared to buying a naked call, a bull call spread has a higher probability of generating a profit since the underlying only needs to rise above the lower breakeven point by expiration.
  5. Volatility Advantage: If commodity volatility increases, the long call benefits while time decay accelerates for the short call, creating a net positive impact on the bull call spread position.

By using a bull call spread, commodity market participants can take advantage of a moderately bullish outlook while strictly defining their maximum risk, reducing upfront costs, increasing leverage, and having a higher probability of profit compared to simply buying calls.

One can buy bull call spreads in the form of derivatives where there are exchange traded options on the relevant raw materials (for example Cocoa on the ICE exchange).

Challenges of Options-based Bull Call Spread Strategies

When using bull call spreads implemented through options to manage raw material price risk, key challenges and complexities include:

  • Liquidity Constraints: Limited liquidity in certain commodity options can make it challenging to enter or exit positions at desired prices.
  • Basis Risk: Mismatches between the option's underlying asset and the actual raw material being hedged can reduce hedge effectiveness.
  • Margin Requirements: Bull call spreads require margin, tying up capital and adding complexity to position management.

ChAI Protect

At ChAI we offer a product that mimics all of the characteristics of a bull call spread, but is embodied as an insurance product. We offer this in markets where there is no exchange traded product (for example in packaging materials) and directly replicate the risk our clients have in terms of the price indices they have exposure to. This means that our insurance product overcomes the main challenges of options-based Bull Call Spreads as listed above

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