Bull Call Ladder Spread

When to Use This Spread?

The bull call ladder spread is best used when you are confident that a security is going to increase in price, but you don't believe it will increase by a huge amount. It's an alternative to the bull call spread, one of the most commonly used trading strategies, that's typically used to lower the amount of capital required to establish the position. It generally results in an upfront cost, but it can be adjusted so that you receive an upfront credit instead.

How to Establish the Bull Call Ladder Spread

The bull call ladder spread is a little more complex than the bull call spread, but it only involves one extra transaction for a total of three transactions. These three transactions can be made simultaneously or, if you prefer, you can use legging to carry them out at different times and possibly increase the potential profits.

One of the transactions is buying calls, with the expectation that they will increase in value due to the price of the underlying security going up in price. The other two transactions are both writing calls, at different strikes, essentially for the purposes of the offsetting the cost of buying the calls.

The first thing you need to do before use this strategy is to determine what strikes you are going to use. You should probably simply buy at the money calls for the long leg of the spread, but you need to put some thought into the strikes for the two short legs. We would advise that you write one batch of options with a strike equal to approximately what price you think the underlying security will rise to, but not exceed, and write another batch of options with the next highest strike.

You can use higher strikes if you choose, but these will be a cheaper price, and you won't receive as much credit to offset the upfront cost of the long leg. The advantages of using higher strikes, though, are that the strategy will require less margin and you can potentially make more profits.

All three legs should use contracts with the same expiration date. For the purposes of showing how the bull call ladder spread can be applied, we’ll use a theoretical example.

Let’s assume that Company X stock is trading at $30, and you believe its price will increase up to around $35, but it will go no higher. You would make the following three transactions.

• Buy at the money calls based on Company X stock, with a strike price of $30.
• Write the same number of calls, with a strike of $35.
• Write the same number of calls again, with a strike of $36.

Now let’s look at the sums of money involved in creating this spread. Please note, these prices are hypothetical and we haven't accounted for any commission costs.

• At the money calls (strike $30) are trading at $1. You buy 2 contracts, each containing 100 options, for a total cost of $200.
• The calls with a $35 strike price are trading at $.30. You buy 2 contracts, each containing 100 options, and receive a credit of $60.
• The calls with a $36 strike price are trading at $.20. You buy 2 contracts, each containing 100 options, and receive a further credit of $40.

The upfront cost of $200 for buying the options is offset by $100 because of writing the options with a higher strike. In this example, you have created a bull call ladder spread for a cost of $100. We now need to look at what the results of this strategy will be, depending on how the price of Company X stock moves.

Profit & Loss Potential

The spread will start to move towards profit as the underlying security (Company X stock in this example) increases in price. The maximum profit will be if the price of the security increases to at least the lowest strike of the options written ($35 in this case) but no higher than the higher strike of the options written ($36 in this case).

If the underlying security increases in price beyond that point, the position will start to reverse and you can lose money if the price goes too high. If the underlying security fails to increase in price, or even falls in price, the maximum loss is the initial investment ($100). Below we have shown what the outcomes will be in various hypothetical scenarios.

Company X stock remains at $30 by expiry

• The options in the long leg will be at the money, and will therefore expire worthless. The ones in both the short legs will be out of the money and will also expire worthless. Therefore, you will suffer a loss of your initial investment, $100.

Company X stock increases to $33 by expiry

• The options in the long leg will be in the money, and worth around $3 each. You own a total of 200, meaning they are worth $600.
• The options in both the short legs will be out of the money and they will expire worthless
• Your profit will be the $600, minus your initial $100 investment, for a total of $500

Company X stock increases to $35 by expiry

• The options in the long leg will be in the money, and worth around $5 each. You own a total of 200, meaning they are worth $1,000.
• The options with a strike of $35 will be at the money, and will expire worthless.
• The options with a strike of $36 will be out of the money, and will expire worthless.
• You profit will be the $1,000, less your initial $100 investment, for a total of $900.
• This is the maximum profit you can make, and it would be the same if the price of Company X stock is anywhere between $35 and $36 at the time of expiration.

Company X stock increases to $40 by expiry

• The options in the long leg will be in the money, and worth around $10 each. Your total holding will be worth $2,000
• The options with a strike of $35 will be in the money, and will give you a liability of around $5 each, for a total of $1,000
• The options with a strike price of $36 will be in the money, and will give you a liability of around $4 each, for a total of $800
• Your profit is the value of the options you own minus your liabilities and your initial investment. This would give you a total of $100 profit.
• If the price of Company X stock increased above $40, your position would turn into a losing one. Of course, you could always close your position early if the security looked like it would rise by that much.

Advantages & Disadvantages

The main advantage of this strategy is that you establish a position where you can profit from a security going up in price, and reduce the upfront costs of taking that position. The strategy is also a flexible one, and you can adjust the strikes to come up with a position that suits you. Whether that is reducing the amount you can lose or increasing the amount you can make. Despite the fact that this is one of the more advanced strategies, it isn't too difficult to understand once you realize exactly what is involved.

The two biggest disadvantages are the margin required and the fact that it can start to lose you money if the price of the underlying security goes up more than expected. The margin requirement can be reduced by writing options with a higher strike, but this then means the spread will cost more to put on. There isn’t really anything you can do to change the fact that the strategy will lose money if the price of the underlying security increases dramatically, although you can always buy to close the short legs if this does look likely, and just leave yourself with a long call position.

Summary

This strategy is best considered as a good alternative to the bull call spread if you want to reduce your upfront costs and are confident that the underlying security won't rise above a certain price. It's considered to be a complex strategy, and we wouldn't recommend it to beginners, but it doesn't involve the complicated calculations that some other strategies do.

The potential profits are fairly high compared to the initial investment required, so there's certainly a lot to be said for using this strategy.