Alternatives to Covered Calls, Part 3
How they can bolster your trading arsenal.
Editor's Note: This is Part 3 in a multiple-part series. Part 1 can be found here, Part 2 can be found here, and Part 4 can be found here.
This series is the result of a question from Minyan Donald, who questioned Steve Smith's suggestion to use the following techniques instead of covered calls:
- Replace the underlying long stock with the purchase of an in-the-money Long-Term Equity Anticipation Security (LEAPS), or long-term call option.
- Rather then selling a single strike call, sell a vertical spread for a credit.
Part 1 and Part 2 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 2011 90 C; Sell SPY Jan 2010 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.
Click to enlarge
You can see that the maximum loss (displayed on the graph) increases by a small amount (compare with graph in Part 2). It's the $210 paid to buy the January 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.
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