When trading options, the simplest move is to buy or sell a standalone call or put option. The benefit to this is that if you are right, you can maximize the gain from the trade. The flip side is that if you are wrong, you could lose 100% of the premium you paid for the option.

To manage risk and reduce cost, many option traders will use a combination of options. Indeed, one of options’ attractive qualities is the flexibility it gives traders to tailor their trading strategies.

Today, let’s take a look at a bull call spread and a bear call spread.

The Bull Call Spread

To execute a bull call spread, you buy a call and simultaneously sell a call on the same underlying stock and the same expiration date but higher strike price. Thus, this strategy combines a long call with a lower strike price with a short call with a higher strike price.

For example, let’s say you are bullish on Advanced Micro Devices, Inc. (AMD), which as of this writing trades at about $75. You like the February $80 call for $6.05. You could just buy this contract, but you decide to reduce your cost so you also sell the February $85 call for $4.20. (These are actual market prices as of this writing.)

You end up with a net cash outflow, or debit, of $185. Note that the second leg of the trade reduced your cost from $605 to $185. (To keep things simple, I am ignoring the negligible commission cost.)

The graph shows your gain and loss from the spread if you held both positions to expiration.

If AMD ends up under $80, both contracts expire worthless, and your loss is the net debit of $185. Note that even if AMD fell to zero, you won’t lose more than $185.

If AMD ends up above $80, then your long call will be exercised and your gain is the difference between the market price and the strike price of $80 minus the $185 debit. Your breakeven point occurs with AMD at $81.85.

But don’t forget that you also have a short call. If AMD ends up at $85 or above, then the shares you get from the long call exercise will be called away at $85. Put another way, no matter how high AMD goes, your gain from the spread will be capped at $315. This is because effectively you buy at $80 and sell at $85 for a $500 total gain, but you also need to account for the $185 debit.

The bull call spread reduces your cost basis, but it also limits your potential upside. Thus, it’s best used on a stock that you expect to have moderate upside during the life of the option.

The Bear Call Spread

If you were bearish on AMD, you could instead execute a bear call spread. In this scenario, you would short the February $80 call and buy the February $85 call. Using the same prices as above, this time you will have a credit (net cash inflow) of $185.

This second graph shows what your gain and loss would be from the bear call spread if you held both positions to expiration.

Your maximum gain would be limited to $185. This occurs when AMD is below $80 and both calls expire worthless. The breakeven point still remains at $81.85. The difference is that if AMD is above $81.85, then you would have a net loss on the spread.

Had you only shorted the $80 call, your maximum loss is theoretically unlimited. However, since you also are long the $85 call, your loss is capped at $315. No matter how high AMD goes, you have the right to buy the stock at $85, then you must sell the stock at $80 for a loss of $5 per share. Subtract the $500 from the $185 credit and you have a $315 loss.

Whereas the bull call spread strategy is best used on a stock you think has moderate upside, a bear call spread strategy is best used on a stock you think has moderate downside.

If you expect a stock to fall a lot, you would have more potential capital gains upside if you purchased an unhedged put or shorted the stock outright. However, if income is your top priority, then the bear call spread makes sense.

Again, keep in the mind that the charts show what would happen if both legs were held to expiration. In practice, you could close one or both legs of the spread anytime before expiration, in which case your gain or loss would differ from what’s shown in the charts.

Editor’s Note: Are you looking for a steady source of income that defies current market risks? Consider the advice of my colleague, the renowned options trader Jim Fink.

Jim Fink is chief investment strategist of Options for Income, Velocity Trader, and Jim Fink’s Inner Circle. Jim’s investment methods have enabled him to take his life’s savings of $50,000, turn the amount into $5 million, and retire early at age 37.

Jim has been sharing his trading secrets for over a decade, giving regular investors not just one, but two different opportunities to get paid every single week. In fact, while the market tanked several times over the last few years, he hasn’t closed out a single losing trade.

To learn more about Jim Fink’s money-making methods, click here.