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

5 Responses to Buying Call Spread vs. Writing Covered Call Calls

  1. Charles 02/02/2011 at 9:33 AM #

    Hi Mark,

    With the recent talk of a pending market pullback I became curious
    about what options strategies there would be for short sellers. I
    tried doing some internet research but really couldn’t find much. As I
    understand it, shares held short are borrowed so I’m not sure how you
    would be able to treat those with options. I’m sure your expertise
    could help.

    Thanks in advance!

    • Mark D Wolfinger 02/02/2011 at 10:46 AM #

      Charles,

      When investing or trading, it is equally as natural to be long as short. Yet, in this country being short, or bearish, has always been looked upon as something for speculators. It’s not. If your research tells you that a company has a business that is not viable and that it will soon be out of business, there is nothing wrong with being a short seller.

      It’s just a matter of looking at things in a mirror. However, there are some limitations

      When bullish you buy shares. When bearish you may sell stocks short. However, your broker cannot always borrow the shares. Thus, you should ask the broker first, if the specific stock you want to short can be borrowed.

      But here, we are dealing with options. So let’s consider some alternatives.

      The simple bullish strategy is to buy calls. In my opinion it’s almost impossible for the average investor to make any money when buying calls, but that’s not the topic for today. The opposite strategy is to sell call options, but that is far too risky for most traders, and your broker may prohibit that idea.

      You may buy puts. Those options increase in value as the stock declines. My warning still holds: It’s very difficult for the average investor to prosper when buying options, but owning puts is a straightforward, low cost method for betting on a market decline. And the rewards can be staggering if you catch a large decline.

      That’s the simple approach. Also easy, but just a bit more complicated is the idea of selling call spreads, using strike prices that are higher than the current stock price. If the stock declines, these spreads will eventually become worthless. These offer much more limited rewards, but the risk of loss (i.e.e, of losing a lot of money) is reduced.

      Similarly, you may buy a put spread which should increase in value when the stock declines. Limited gains with limited losses.

      Charles: These are just outlines – things to consider. If you truly want to get involved, you must have a much better understanding of how these strategies work. Please do not run to your broker, open an account, and start using options.

      But you should learn more about them – so you will be ready when you decide to make the bearish bet.

      I’ve blogged on the idea of trading spreads before. Just click on the word ‘categories’ directly below to find links to such posts. If you prefer a lengthy, detailed explanation of how all of this works, my Rookie’s Guide to Options offers that.

      Take your time to learn the rules, but when long, traders buy shares and then sell them. When short, traders sell first and buy later. There is nothing complicated, unethical or anything else wrong with that idea.

      Thanks

  2. Robert 02/02/2011 at 11:32 AM #

    Mark,
    Let assume that one wants to buy a stock, and I really mean wants. On the other hand one would not be upset if the stock price ran away and money was made, basically one is bullish on the given stock and wants to make money if stock goes higher or own it if drops lower. One is considering two possible courses of action (assumption stock is at $55):
    1) Sell puts $50 Jun 2011 @2.15
    2) Sell the same puts, buy $55 call Jun 2011 @4.10 and sell $60 call Jun 2011 @2.15
    Could you please comment what needs to be taken into consideration choosing one vs the other.

    Thanks,
    Robert

    • Mark D Wolfinger 02/02/2011 at 12:59 PM #

      Robert,

      1) The put sale is simple to understand (and I know that you do); Keep the premium or own the stock at an acceptable price.

      2) Your alternative is to buy a call spread – in addition to the put sale. Thus, the true question is whether buying the call spread suits your needs.

      a) The cost is $1.95. If the stock is <$50 at expiration, your stock purchase price is no longer as attractive. But that's to be expected when you pay $1.95 more for the position. b) When the stock finishes between $50 and $55, no real harm is done. You earn enough profit to pay the commissions, but this is not the goal you had in mind when selling the puts. And don't forget that the put sale entails some risk (stocks sometimes move much lower, even when 'one' is bullish), and this result means in return for taking that risk, you have no reward. Yes, you had the low cost possibility of earning money on a rise in the stock price. c) Let's assume you hold through expiration (only because discussing the possibilities would be endless if we have to consider exiting early). You are paying $1.95 with the hope of earning up to $3.05. That's not so bad, if bullish. However, it's a far different play than put selling.

      Look at it this way

      The call spread requires the stock to move $2 higher before you earn a profit. And to earn the same $2.15 profit, the stock must advance to about $59. The put sale requires only that the stock perform better than dropping by 5 points.

      Which is more likely?

      Buying the call spread offers a higher profit, but it also leads to scenarios in which you took the risk of selling puts and end up with nothing.

      And look at the probabilities. The chances of earning that $215 is way more than 50% (look at the delta of the 50 put to see the chances that it will finish ITM). The chances of earning ANY profit on that $55/60 call spread are less than 50% – the stock must move to $57 just to get to even on the call spread.

      That’s possible, but the chances are far less than the chances of earning a profit from the put sale.

      Thus, better odds of success and decent profit potential for selling the puts. If you ask why the put sale looks so much better in this light – its because the risk of a large loss is possible when selling the naked puts. Higher risk, higher reward. in this specific scenario, the loss is not your concern. You WANT to buy the shares. Thus, this is a simple choice to me. I sell the puts.

      If you want to be safer, you can buy the 45 puts. But that’s another story.

  3. Dave 02/02/2011 at 9:25 PM #

    A Q&A with Mark

    QUESTION:

    (Disclaimer: I know this isn’t the exact terminology you prefer, so I apologize for that)
    I was trying to apply the equivalent of a bull spread position on DBA, when I ran across something I did not expect as a option novice. Although I believe these 3 positions to be equivalent, there is a large difference in cost between the call bull spread, the put bull spread, and the
    collar.I am wondering why that is.
    Example:
    DBA @ 34.80
    apr call 33 @ 2.50
    apr call 37 @ 0.65
    apr put 33 @ 0.55
    apr put 37 @ ~ 2.2x (not listed)

    33/37 bull call would be $1.95
    33/37 bull put would be ~1.70
    100 DBA, put 33 put, sell 37 call would be -.10 for the option portion

    Why is there almost a $2 difference in cost for the same position?
    My guess is that since DBA is so hot right now calls have become expensive.
    Additionally, there’s probably some carry cost of having to buy the 100 shares
    of DBA. But not sure.

    Thanks,
    Dave

    ANSWER:

    The Apr 37 put is listed if you check the CBOE for your option quotes:

    No need to apologize, your message is completely understandable.

    As long as there is no dividend, and there is none, then the sum of the call spread and put spread must equal $4 (in this 4-point example)

    If the call spread is 1.95, then the put spread will be near 2.05 (If you don’t know why that’s true, let me know)

    As I write this, the Put spread is $2.05 to $2.40 and the call spread is $1.65 to $1.90. DBA is 34.76

    You could probably buy the call spread near 1.80 or sell the put spread near 2.15 to 2.20. If 1.80 and 2.20, that would be equivalent prices (because the sums is $4)

    The collar is: 34.76 + 0.65 for the put – 0.65 for the call. (Even money for the options)

    In looking at the equivalency of the collar, one does not look at the cost. Instead, it’s the profit/loss. If, at expiration, the stock is below 33, the loss from buying the put (probably meant call) spread (the premium paid) and selling the put spread ($4.00 less the premium collected) are the same (not to the penny because markets are not that efficient. But they are VERY near each other). the collar would lose $1.76 (but stock at 37.76 and sell at 33). add the small cost to carry the position, and it’s near that $1.80 loss for the call spread.

    Make the similar calculation for a price above $37. Although we are not going to look at every price between 33 and 37, I hope you trust that they also provide equivalent results.

    THANKS. MAKES SENSE.