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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.


2009-11-01_2053Part_IV_1

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.

2009-11-01_2227_IV_102C

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:


2009-11-01_2253puts

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.

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