Double Dunk Your Covered Calls

Here's a way to tweak a traditional hedging strategy when you're feeling aggressive.
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Covered-call writing is one of the most popular options strategies. It's straightforward (you buy stock and sell call options on a 1-to-1 basis) and is a conservative way for investors to hedge their stock holdings while maintaining a bullish position.

At the recent

Traders Expo I attended, Jon Najarian, chief market strategist at PTI Securities, offered a strategy that puts a twist on the covered-call concept, turning the once-conservative defensive strategy into a more active position with much greater profit potential.

Najarian's plan essentially consists of laying a ratio call spread on top of a long stock position. Its construction consists of three easy pieces. For example, a position might look like this:

  • buy 1,000 shares of XYZ at $25

  • buy 10 April $25 XYZ calls

  • sell 20 April $30 XYZ calls

Note that the position resembles a

covered call in that the net long (shares plus long calls) is equal to the number of shares shorted and the maximum profit is achieved once the stock rises above the strike price ($30 in this example) of the short calls. Any further price gains merely result in offsetting positions.

Najarian and his firm originally introduced this strategy, which they called Current Portfolio Repair, or CPR, as a way of recouping loses on existing stock holdings. It lets you double down on a current holding without adding additional risk. But it can also be used to establish new positions, so perhaps I'll refer to it as the Double Dunk, due also to the fact that Najarian is known as

Dr. J in the options industry.

Low Expectations

But remember some preconceived notions about both covered positions. Most investors view covered calls as a good strategy on essentially stable stocks and often use this against a long-term holding that's owned from a much lower cost basis, or a buy-write that is initially established on a stock you believe will move only moderately higher. Both cases are predicated on limited near-term upside potential. This is why a preponderance of covered call positions are placed on some of the least volatile issues.

But selling inexpensive calls not only diminishes two main attractions of covered calls -- gaining downside protection and generating income -- it can also force you into selling calls with lower strike prices, greatly reducing your upside profit potential.

Mathew Shapiro, president of MWS Capital Consultants, believes too many people employ covered strategies that neither reduce risk nor provide enough upside return. "In many situations, people would be better off simply selling off some shares if they need to reduce their exposure," he said. Shapiro recommends using covered calls on high risk/reward stocks as a way to add beta to the margins of your portfolio.

The notion of selling calls on high-volatility stocks, and therefore limiting your upside return, may be anathema to those looking to get long on a highflying tech name, but it's consistent with the fundamental concept of selling options when they are expensive.

High Volatility Required

Thus, anyone employing this strategy needs to be comfortable owning volatile, high P/E stocks and aware of the associated risk. That's because the best candidates for Najarian's Double Dunk are stocks with options trading at high implied volatilities.

The key to maximizing the position's potential is the ability to establish the ratio spread for even money (or preferably a slight credit) while using strike prices as far apart as possible. The allure of this strategy, according to Najarian, is that it "lets you control twice as many shares between the strike prices without any additional risk.

For example, let's look at establishing a position in

Sepracor

(SEPR)

, which has at-the-money options sporting an implied volatility in the 80% range. On Monday, you could buy 1,000 shares at $28.65, buy 10 April $27.50 calls at $4 and sell 20 of the April $32.50 calls for $2 a contract. This provides a $5 separation in strike prices at no cost.

Compare this with a stock like

General Electric

(GE) - Get Report

, whose at-the-money calls have 18% implied volatility. With GE shares trading at $33.42, its April $32.50 calls are priced at $1.40 but the $37.50 strike is worth a mere 10 cents, making the 1-by-2 ratio call spread (buy 1 April $32.50 call, sell 2 April $37.50 calls) cost a net $1.20 debit.

Generally speaking, it will require implied volatilities of 45% or higher to allow you to implement a ratio spread (with a sufficient strike separation and no more than six months until expiration) for even money or better.

The risk in the Sepracor position is identical to being long 1,000 shares of Sepracor at $28.85, but would deliver more than double the profit for any rise in price up to $32.50 before the April expiration. Remember: Like a covered call or a vertical put spread, the maximum profit is achieved once the underlying shares move above the strike price of the call options sold short.

The table below provides a snapshot of the position's value at various price points at the April expiration:

If you were merely long 1,000 shares, you'd have needed Sepracor to rise an additional $5, or 30%, to $37.50 to match the $8,885 maximum profit achieved here through a 13% move. The loss incurred if the stock decline is equal to simply being long 1,000 shares.

You may wonder how this compares with a regular covered-call or a vertical bull spread. The maximum profit of a 1,000-share buy-write in which 10 April $32.50 calls were sold is $5,850. But it would also provide $2 of downside protection, giving you a break-even point of $26.85.

As for the vertical bull spread, if you'd bought the April $27.50/$32.50 vertical spread for $2 on a 1-to-1 basis 10 times (buy 10 $27.50 calls and sell 10 $32.50 calls for a total net debit of $2,000), you would have achieved a maximum profit of $3,000 at April expiration.

While losses mount in the Double Dunk and regular covered call position as the price of Sepracor declines, the maximum loss of the vertical spread is limited to its cost, no matter how far the underlying shares fall. (I'm purposely not comparing the establishment of the 1-by-2 call spread on its own because the number of calls sold short is greater than the number of contracts long. This can create a position with a delta that can turn negative and become increasingly bearish as the price of the underlying rises, ultimately resulting in unlimited losses if the stock continues to climb.)

Keeping the Options Open

Najarian points out that the profit doesn't have to be limited. "If you still believe the stock has room to run, you simply roll the short calls up

move to a higher strike and out

to a later expiration date as soon as the stock crosses the higher strike price," he said. Najarian has been using this strategy in

Broadcom

(BRCM)

over the past few months.

One way to reduce risk would be to use LEAPs or long dated in-the-money calls instead of buying shares in the underlying stock. But remember, this position still has substantial exposure and should only be established in stocks in which you have a bullish outlook.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.