Covered Call Alternatives. III

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.

Reminder: 

Buy SPY Dec '11  90 C;  Sell SPY Jan '10  106/109 call spread

  • The
    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.
  • Profit
    potential is no longer limited.  This position contains a long call, and that provides unlimited upside potential. 


2009-11-01_2000Part_III_1

You
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.

2009-11-01_2013_1x3x3

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]

2009-11-01_20221x10x10

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.

to be continued

505

6 Responses to Covered Call Alternatives. III

  1. Dave 11/04/2009 at 2:18 PM #

    I like this idea and your accompanying explansition and graphs.
    A question about as you approach the near term expiry …
    Your graph on selling 3 spreads only shows a small wringle in that 106/109 range, hence I assume the graph represents the risk curve today. How would you treat this play if it looks like spy is heading for closing around 109 towards the Jan 10 expiry?
    Correct me if I’m wrong, but potentially the 90 calls would be worth $190+remaining premium & the spread would be at it’s max loss of 3*($300 – $115) ~ $500. So you’re looking at a loss at this particular point in time even though you were correct in your bullishness. It doesn’t seem like selling 2 or 3 of these spreads is overdoing it like your example of 10, but either way it seems when you’re selling multiple spreads you may be faced with this potential situation. How would you handle it / prevent getting into this?
    And this brings up another general question.
    In a strategy similar to this where one is planning to sell shorter term options repeatedly against a longer term option or against the underlying itself. What are the tradeoffs of selling near terms against it every month versus selling say a 3month out against it 4 times a year? I’d imagine the monthly sale gives one the highest potential profit because you would always be riding the steepest theta decay. I’d also imagine that the monthly sales has the same -gamma issue that you’ve written about extensively. Or are there some subtle differences here because you are selling “against” something?

  2. Mark Wolfinger 11/04/2009 at 3:26 PM #

    1) First, I don’t think you will have any interest in doing this trade after tomorrow’s post. I’m taking a careful step-by-step approach to getting where I’m headed.
    2) I would buy in the Jan spread and sell an appropriate Feb or Mar spread. When using these long-term options, the intention is to own the position for a longish time.
    3) Yes, it’s the risk curve as of the day I collected the data – last Friday.
    4) The idea of discussing the sale of multiple spreads is illustratative. I did not suggest that this speciifc play was either good or bad. But, I don’t think much of it as a standalone strategy.
    In fact I am replying to Donald’s question regarding Steve Smith’s comments. Thus, this post and the whole series, is not a recommended trade. Although tomorrow’s finale is such a recommendation. And it’s one I have made more than once.
    5) At 110, the Dec 90 calls would not be worth 190 + premium. They would be only 20 points ITM.
    6) If I were bullish I would never do this spread with the sale of multiples. That would be foolish. However, if I needed upside protection for a portfolio that consisted on iron condors, then this is a perfect adjunct to that portfolio. That’s where I’m headed and that’s tomorrow.
    For clarification: If I suggest making a bullish trade, there is no reason to assume that I am bullish or that I am predicting anything specific about market direction. I never make market predcitions. But, if I say the trade is bullish – and offers good insurance for an iron condor portfolio, that is an entirely different meaning. It does not suggest bullishness. Instead it suggests fear of a bull market.
    Let me know how you feel about all this after tomorrow’s post.
    7) Choosing which calls to sell in any option writing strategy requres a lengthy discussion. I provide such a discussion in The Rookie’s Guide to Options.
    Suffice it to say that near term options provide the highest potential annualized profits because they have the most rapid time decay. That comes coupled with the highest negative gamma. Hgher reward = higher risk.
    Selling longer-term options reduces both time decay and negative gamma. It provieds a higher price for the option, and thus, greater downside protection.
    It’s a trade-off, as is almost every other option trading decision Gain something, give up something else. Trade-off.
    No there are no subtle differences. If you sell naked, sell a covered call, or write against a longer-term call option, the sale part of the trade has it’s own characteristics, separae from the other part of the trade (if there is another part).

  3. Rob 11/04/2009 at 5:44 PM #

    However, if I needed upside protection for a portfolio that consisted on iron condors, then this is a perfect adjunct to that portfolio. That’s where I’m headed and that’s tomorrow.
    Mark, the suspense is killing me.
    On a serious note, I’m enjoying this series of posts. Great job!
    Regards, Rob

  4. Mark Wolfinger 11/04/2009 at 7:02 PM #

    Thanks.
    There should be no suspense. It’s an iron condor adjustment I’ve
    written about
    previously.

  5. Michael 06/29/2012 at 11:34 AM #

    Mark,

    This is a fascinating series, I’m sorry it took so long for me to find it! Please help me understand… selling a call spread is a bet that the underlying stock will go down. (Maybe because it’s been a while and I can’t see the charts) but how can having a long trade coupled with a short trade result in an unlimited profit trade?

    • Mark D Wolfinger 06/30/2012 at 10:38 AM #

      Michael,

      a) There are no unlimited gains. When you sell the call spread, your max profit is the cash collected when selling the sparead.

      b) The underlying does not have to go down. If it sits where it is, that works also. And the trader can even profit if there is a small rally. As long as the option SOLD remains out of the money, the spread achieves maximum profit when expiration arrives.

      This strategy is a tradeoff. No unlimited gains, but a high probability of winning.