This series is the result of a question from Donald.
Part I and Part II set the stage. Today we'll look at the suggested strategy and the benefits of adding it to your trading arsenal.
The modified strategy calls for buying one LEAPS call and selling a call spread, instead of just writing a covered call. This has two major effects on the position, one of which is readily visible in the graph.
Buy SPY Dec '11 90 C; Sell SPY Jan '10 106/109 call spread
premium collected is reduced. In our example, the $109 call costs
$2.10 and the premium collected for the spread becomes $1.15 instead of
$3.35. That's the bad news, and reduces the amount of downside
protection from 3.35 points to only 1.15.
potential is no longer limited. This position contains a long call, and that provides unlimited upside potential.
can see that the maximum loss (displayed on the graph) increases by a
small amount (compare with graph in Part II). It's the $210 paid to buy the Jan 109 call.
The maximum profit is no longer capped, but instead has no upper limit.
This position, using the long-term call option or the underlying stock, works for the extremely bullish investor who likes the idea of writing covered calls, but still wants the chance to win big on a huge rally.
The exciting part of this trade idea is that it allows for the sale of extra call spreads. In other words, instead of selling just one call spread per long term option, the investor can sell multiples. That puts a temporary damper on the upside, but because the position still contains an extra call, the upside potential remains unlimited.
Here's the same trade with the sale of three Jan 106/109 call spreads, instead of only one.
The downside is improved simply because extra cash was collected by selling two call spreads. The upside was cut – but only by the possibility that the 106/109 call spread reaches maximum value. And any move beyond the upper strike price (of the Jan call spread) once again increases profits.
Still bullish, with a downside that's not as bad. That's seems like a good combination to me. Keep in mind that as expiration nears, the huge upside becomes more and more remote, but it's always present – just in case there is ever an upside black swan event.
Let's take this play one additional step and look at the graph if 10 call spreads are sold, instead of only three. The point of this trade is to illustrate that you can go too far. Sure, the ultimate upside is always going to be a winner, but if this trade is made to produce a profit when the market rises, there is a limit to how many spreads you can sell. [Please don't ask about the limit; it's going to depend on which option you own and which spreads you sell. More on this in Part IV]
Selling all those extra call spreads makes the downside better. This is not an efficient method for downside protection. In fact it's a very poor choice.
We can do better
This strategy works equally well when using puts, producing a pretty downside. That discussion is reserved for Part IV.