Buying Call Spread vs. Writing Covered Call Calls

Mark,

I enjoy reading your blog for quite some time now. I’m very glad I found it as it helped me clarify a lot of things regarding options. So thank you for that education.

Because I wanted to know more details especially for risk management and proper trade execution I recently bought your two books Create Your Own Hedge Fund and The Rookie’s Guide to Options. In both books you are explaining conservative strategies as Covered Call, Collar and Writing Cash Secured Put.

I’m trying to test them via Paper trading. However I would like to ask you something related to cash secured puts. When you enter this trade you are bullish. As with covered call you are carrying significant risk when market goes down.

You don’t have to be bullish. All that’s necessary is that you are not bearish. Neutral markets are also good for these strategies. But yes, there is downside risk. No question about that.

One way to protect against such “big” loss seems to me might be to enter vertical bull spread instead. I guess this will be somehow counterpart of collar for call side. I’m wondering why such strategy is not listed in the conservative list of strategies. Is it because it is not income efficient or I’m I missing some other point?

You are not missing anything. If you buy a call spread, (or sell a put spread with the same strike prices), that is equivalent to a collar – same risk, same reward – but much easier to trade. It’s apparent that you already understand that.

The reason this idea was not included in the earlier book (Create) is because of what I was trying to do with the book. The idea was to get readers started using options. I decided that including many examples would be better than adding additional strategies. There is another reason. Many brokers consider spreads to be ‘complex’ and ‘complicated’ and they do not allow their less experienced traders to use spreads. Ridiculous, I know. However, that’s the way it is. So I kept it simple in the first book. In the Rookie’s Guide, the chapters on equivalency and credit spreads make it clear that these trades are all equivalent (sell put spread, buy call spread, buy collar).

The reason for not including ‘debit spreads’ and only writing about ‘credit spreads’ is that the vast majority of traders prefer the spread in which they collect cash, rather than spend cash. We know they are equivalent trades, but sometimes certain trades just ‘feel better’ – especially when the trader has not yet learned that the trades are essentially interchangeable.

I agree that adopting one of these spreads is far (far) less risky than the covered call or cash-secured put. The reward is also less, but I believe it is a good trade-off to take the safer route.

Based on stated above I “tested” such approach last Friday on weekly option with Ford stock (Friday close price 16.27). I sold “Feb 4, 16P” for 0.16 and bought protection “Feb 4, 15P” for 0.03 (i.e. net credit 0.13 which is 0.8% of 16 strike price with DP – downside protection, or downside break-even, 15.87 for week. In theory, for a month I can get 3.2% ROI on weekly – I know this is ideal thinking but much better return than regular monthly option approach. On monthly Feb 18 and same strike bull spread I would get 0.27 credit (all related to Friday prices). If I use naked put on Feb 18, then I would select the 15P for 0.15 because of better DP – 1.15USD.

Yes, Weeklys offer a better return. But that should not surprise you. The less time in the life of any option, the more rapid the time decay and the greater the risk – if the stock moves toward and then through the strike. One month options offer a better return than longer term options. Thus, Weeklys offer a better return than ‘regular’ front-month options. This higher annualized reward does come with elevated risk, so it is not for everyone. Weeklys have become very popular quickly. Buyers like the cheap ‘action’ and sellers like the rapid time decay. If you are comfortable with holding these trades, then there’s nothing wrong with trading Weeklys. I know it’s a paper account, but if you treat it as if it were real, you will learn a lot about how comfortable you feel with those trades.

Do you think I’m picking only “penny/dimes” on this approach? Do I risk too much from your point of view?

No. If you want to trade Ford, only 1-point spreads are available and it is far more important to trade the stock you want to trade (F in this case) than to worry about other considerations. I believe you are making reasonable and effective trades. Just remember that your long-term results are going to depend on how well you manage risk. There is absolutely nothing wrong with selling a $1 spread for that 13 cents. I object to ‘picking up dimes’ by selling a 10-point spread for thirteen cents, but when it’s a one-point spread, that’s equal to collecting $1.30 for a 10-point spread. That’s fine.

Additional question related to it. Is it good to use weeklies on collar/covered call/cash secured put strategy (I’m using IB so commissions on trade are not that significant to overall trade price) – my thinking about weeklies is to address possible steady declining market which makes “proportionally” less move over week than over month?

‘is it good’ to use Weeklys (note the odd spelling)? It’s acceptable is you prefer to trade short-term options. There is nothing ‘bad’ about it. However there is higher risk (gamma explodes when the stock approaches the stock price). Too risky for me, but we each define our own comfort zones.

L.

890

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