Covered Call Alternatives. IV

In the final part of this series, we'll consider two additional modifications to using a call spread, instead of a call – when modifying the covered call writing strategy.  This position already looks nothing like a covered call, so I'm not going to be using that term any longer.

Part I, Part II, Part III.

As pointed out in the original article that spurred this discussion, it's not necessary to use either stock or long-term options.  There's no reason not to use options that are far less costly to buy.  Let's look at an example in which we buy SPY Jan 90 calls instead of the very long-term SPY Dec '11  90 calls (which we used in Part III).  We'll still sell 3 Jan 106/Jan 109 call spreads.


The downside is better, but imagine how much better it would be if we bought less expensive calls.  Let's look at this position, substituting Jan 102 calls for the Jan 90 calls.

Jan 102 calls cost $5.70.  The cost of this position is $570, less 3 x $115 (premium from selling each call spread), or $225.


By cutting the net cash required to purchase this investment, the downside risk has been eliminated, or at least severely cut.  But look at the big picture.  If you need some protection for a portfolio that has upside risk this is a very inexpensive way to get that protection.

Note the progression:

  • Begin with a covered call
  • Substitute a LEAPS call for the stock
  • Sell a call spread, instead of a single call
  • Sell multiple call spreads
  • Buy nearer-term options as the long, replacing the LEAPS call
  • Buy a less costly near-term option

This final spread bears no resemblance to a covered call position, yet we moved from a covered call – with significant downside risk – to a much less risky position. 

  • The downside is much better 
  • The position still shows a good profit when the market undergoes a big move to the upside
  • This position can never* lose more than the initial debit when the market moves higher

*As long as you don't sell too many spreads.  At expiration, the 102 call is worth $700 with SPY at 109.  The three call spreads are worth $900.  This trade can result in a small loss ($225 cost plus the $200 resulting from a 109 expiration price). But it's worth it if the portfolio needs good upside protection.  If you choose a 2:1 ratio, then there is never an upside loss, other than the original debit.

NOTE: This is not the right position for a covered call trader.  This is completely different.  This is an inexpensive bullish play that provides excellent protection for an iron condor trader.

It's the possibility of big profits (or buying protection against big losses)
resulting from a big upside market move that makes this strategy so attractive.  And it's the reason I've been recommending this specific strategy as one good method for insuring iron condor positions.  I've been using it successfully for the past few months.

The beauty of this position type is that it works for the downside also, using puts.  Here's one graph for a typical put position:


Is this an idea you can use for your portfolio?

Donald – I think we've moved a long way from your original question.  Thanks for suggesting this topic.


15 Responses to Covered Call Alternatives. IV

  1. Mark Wolfinger 11/05/2009 at 2:11 PM #

    Good follow-up.
    I’ve deleted the question above, because it is so lengthy. But I will post a response Monday and Tuesday, Nov 9,10. 2009

  2. Dave 11/05/2009 at 2:16 PM #

    Thanks Mark. I definitely am intrigued by this idea and will explore it further.
    I found your comment about trading this for the past few months interesting. Is this an example of why learning never stops because even a 30-odd year veteran can still find new ideas?
    If you were implementing this startegy to insure an IC, would one typically purchase the long call/put at the start of the wing?
    I think I understand your use of the term bullishness as we talked about in yesterday’s blog comments. In this context, it is “fear of a bull”.
    However, more generally, one thing I don’t completely grasp about these IC insurance ideas is why is it interesting to have the possibility of big profits resulting from a big upside market move? I know this sounds funny, but my logic is that if one is getting into a IC because they want a non-directional play and are assumably somewhat market neutral, it would seem like this big profit on big move idea is counter to the original idea for opening the trade. To me, it would seem like a more symbiotic insurance policy would be to neutralize big losses on big move … perhaps by selling a FOTM call/put to complete the spread, which would give better profit when things go according to the original plan. I’m guessing the reason to do it way you are describing is because A.) selling the FOTM option is probably not worth much B.) being net long on the call/put of your insurance probably reduces your -gamma better than my proposal and that the potential for profit on a big move is just a side-effect of -gamma reduction. But, wanted to get your thoughts on this …
    And separately, if one was wanting to put on a directional play but wanted a profit/risk trade between a naked call and spread, is this a good candidate for that? Or is there other strategies that would fit that bill better?

  3. Sina 11/05/2009 at 2:44 PM #

    Do you have any rules as to when to remove an adjustment? e.g. market drops, put on a put adjustment, and market moves back up strongly like right now. thanks

  4. Mark Wolfinger 11/05/2009 at 2:55 PM #

    No, no rules.
    When you adjust a position, obviously the market can move against that trade.
    I tend to hold the adjustment as long as I own the original position. But I certainly see the merit in selling out the adjutsment at a loss – as a secondary adjustment.
    I don’t believe either method is better than the other, and thereore don’t have a valuable opinion.
    If the adjustment was inexpensive, there is little to lose by holding. When it’s more costly, that’s when this is an important decision to make.
    As I said, I hold them. But if it makes you uncomfortable, then I’d let your comfort zone rule and unload. Getting whipsawed os one of the unpleasant results when trading negative gamma positions.

  5. Steve 11/06/2009 at 2:12 AM #

    Very good series of articles.
    As a short put is the “same” as a covered call, can you do the same sort of development for a short put position?

  6. Mark Wolfinger 11/06/2009 at 7:21 AM #

    Definition: S + C – p
    Stock is equivalent to long call and short put (same strike and expiration)
    Thus, C = S + P.
    Buy stock, buy put, equivalent to a call.
    See Rookies Guide to Options, Ch 15 for more on equivalents.
    Also here

  7. Donald W. 11/07/2009 at 6:08 AM #

    Thank you for your 4 part reply. Enjoy the articles!

  8. Rob McAfee 11/10/2009 at 8:28 AM #

    Thanks for the excellent series! There is just one thing I don’t understand. In my own paper plotting, using the example where you write 3 SPY 106/019 call spreads, it’s pretty clear that profit decreases as you move through the 106 to 109 range at expiration. This makes intuitive sense, since in that range, you’re losing 3 for every 1 you gain.
    If you instead write 1 call spread, that should result in the profit curve being flat as you move through spread at expiration. Profit is the same at 106 as it is at 109 and every point in between. It picks up again after clearing the upper strike.
    So my question is why do your P/L charts show a monotonically increasing profit? I would expect the example using 1 call spread to show the profit curve go flat between the strikes of the spread, and anything with more than 1 call spread should show a decline as we move from lower to upper strike.
    Thanks for clarifying,

  9. Jon 11/10/2009 at 9:06 AM #

    Mark, thanks for writing these articles. I am new to the blog and really enjoying them.
    You mention that this strategy may be a way to adjust an iron condor. Of course, I realize that you could not give specific advice, etc, but what would be the best way to utilize this strategy?
    Would you wait until price moved to your short strike, then place the entire trade? Would you trade your original IC with an extra long at the wing, then place the additional credit spreads when price moved to the short strike at the wing?
    Thanks again!

  10. Mark Wolfinger 11/10/2009 at 9:50 AM #

    As I say repeatedly, there is no ‘best’ way because we each have our own needs and comfort zones.
    Detailed reply as part of blog post tomorrow, Nov 11, 2009

  11. Mark Wolfinger 11/10/2009 at 10:04 AM #

    The charts are drawn as of the day the trade is made.
    As expiration nears, your idea of how the charts should look becomes reality.
    Detailed reply via blog post tomorrow, Nov 11, 2009

  12. Steve Bokros 11/10/2009 at 3:39 PM #

    Thank you for these posts, they are very informative. Here is my question: What if the reason you want a collar is to “capture dividends” with reduced risk? Are there better ways (less cost, more profit potenial with same risk) than a simple collar? Again, thank you for your posts.

  13. Mark Wolfinger 11/10/2009 at 4:40 PM #

    I’m happy you like the posts. Share them with friends who are investors!
    To capture the dividend you must (obviously) own stock.
    If you want reduced risk, one alternative to the collar is to own deep in the money (but not too deep) calls. If the stock collapses prior to ex-dividend date, your losses are not tiny, but they are limited. But, once you exercise for the dividend, you will own the stock into the future. Thus, this idea has little merit.
    When you own stock, owning the put options is the best, most efficient way to own protection. selling a call – to complete the collar – helps pay for the put. If you choose not to sell the call, you will find the collar to be far too expensive.
    All in all, the collar suits your needs. Just remember if the call you sell is too cheap, there’s not much to gain by selling it. If it’s more expensive, it may be far enough in the money when ex-dividend day comes around, and it’s owner may exercise and you may not collect the dividend.

  14. Michael H. 11/10/2009 at 7:46 PM #

    Mark, great series.
    Question: I’m trying to understand the difference between this strategy and a backratio. Both are negative theta postive vega, and seem to have similar performance characteristics.
    One caveat I could think of is the vega sensitivity. I bought some backratios with the VIX at 70 and – whaddya know! – realized my debit loss pretty quickly when the VIX plummeted (at least it was a quick education). Of course, with puts and increasing volatility they look really good.
    I really enjoy your site. Thanks!

  15. Mark Wolfinger 11/10/2009 at 8:22 PM #

    There’s a world of difference between this spread and the backratio. If you don’t mind I’m going to refer to it by its more traditional nomenclature, the back spread.
    As you say, there are some significant similarities.
    But, the performance is not as similar as it looks. The big upside profit (with a call back spread) is much larger – simply because you own more long options.
    In most cases, the call back spread is opened for a cash credit, so no loss is possible on a downside movement in the stock.
    The most important difference is the passage of time when the underlying fails to make a big move. The back spreader can incur a large loss when the underlying moves slowly towards the strike price of the options owned.
    The 1 x 3 x 3 (as yet un-named) spread never incurs a significant loss, and can earn a profit when the upside move is small.
    And, as you know from personal experience, the back spread is much more dependent on implied volatility because it has much more positive vega.
    Choosing to own vega when VIX is 70% is certainly going against the odds. But you could have been a winner if the move in the underlying had been large enough to overcome the IV drop.
    Thanks for the comment.