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Alternatives to Covered Calls, Part 4


Start with a covered call, finish with a profit.

Editor's Note: This is Part 4 in a multiple-part series. Part 1 can be found here, Part 2 can be found here, and Part 3 can be found here.

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.

As pointed out in the original article that spurred this discussion, "The Truth About Covered Calls", 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 January 90 calls instead of the very long-term SPY Dec '11 90 calls (which we used in Part 3). We'll still sell three Jan 106/Jan 109 call spreads.

Click to enlarge

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 three multiplied by $115 (premium from selling each call spread), or $225.

Click to enlarge

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
3. Sell a call spread, instead of a single call
4. Sell multiple call spreads
5. Buy nearer-term options as the long, replacing the LEAPS call
6. 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 -- well, 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-to-1 ratio, then there's never an upside loss, other than the original debit.

NOTE: This isn't 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:

Click to enlarge

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No positions in stocks mentioned.

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