Steve:Why do a covered call over a bull call spread? The spread lowers your risk considerably, ties up less cash and your upside is not as limited. Last week's article on
Apples and Oranges Are Both FruitfulIt's not an apples-to-apples comparison, but we can still compare the suggested covered call in Foundry Networks ( FDRY) to a vertical bull call option spread. Based on last Wednesday's prices, the covered call was established by buying FDRY at $16 and selling the May $17.50 call at 80 cents a contract. This provided a break-even price of $15.20 and a maximum profit of $2.30 (or $230 per 100 shares covered), for a 14.3% profit over the next four weeks. One that same day, you could buy the May $15 call for $2 and sell the May $20 call for 25 cents a contract. The total risk is the cost or net debit of $1.75 per spread, while the maximum profit is $3.25 should Foundry rise above $20 at the time of expiration. You could establish the $15/$17.50 call spread for $1.25, but the even money risk/reward (i.e., the $1.25 maximum loss or gain) seems less attractive than a covered call or a wider strike spread.
On the surface, the risk/reward looks better for the vertical spread if you're anticipating that FDRY will move above $20, or below $14.25 -- a 25% price increase or a 10% decline over the next four weeks. But the profit profile tilts clearly in favor of the covered call should Foundry stay between $15.20 and $18.50, or a 20% price range between now and expiration. For example, with Foundry at $16.75, the covered call would realize a $1.55 profit, or $155 for each 100-covered-share position. But the vertical spread reaps nothing, as $16.75 represents the break-even point. As far as risk management, one way to create a comparable risk profile would be to apply the vertical spread's cost or maximum loss (in this case $1.75), and use that amount to set a stop-loss limit order in the covered call position. For example, because the vertical spread carries a risk of $1.75, you could enter a stop-loss order to sell the long Foundry stock at $14.25, which is $1.75 below the original purchase price of $16. However, it you're using a stop-loss to manage the risk of a covered call position, it's important to buy back (or cover) the short call option once the stock's stop-loss price is hit. I'd suggest using a "one-triggers-other" type order, which allows the position to be closed with a single order and doesn't require constant monitoring of the stock's price. The necessity of buying back the calls will increase the loss incurred, making it incrementally larger than the maximum loss of the vertical spread. The cost of the calls will depend upon the amount of time remaining until expiration. If Foundry shares hit $14.25 on May 14 (one week remaining until expiration), the May $17.50 call will have a theoretical value of less than a nickel, or $5 per contract. While it might seem tempting to let it expire worthless and avoid the commission cost, discipline dictates closing out the position entirely and not leaving yourself naked short. Certainly there are legitimate arguments to be made for both positions.
Hi, Steve: Good article, except ... you said one way to pick covered calls was to take names that were off 20% in the near term and had rich premiums. I believe the basis for instituting a buy/write should be a favorable chart pattern, where a stock is holding key support or is about to break out of resistance. In addition, one has to be comfortable with the valuation and the fundamentals of the company. Screening for highest returns based on premiums and or a percentage decline from a peak can get you into trouble fast. -- E.S. Here again, the reader is addressing his preference for applying particular strategies to specific situations. Because most covered calls (or buy-writes) are done as an ongoing program to generate income from relatively stable stocks, I was trying to point out another way to look at what is generally considered a conservative position. By scanning for beaten-down stocks with relatively high implied volatilities, I was offering a way of stepping into the breach by buying higher risk/beta names and capturing short-term gains. These were basically presented as a single (one-month) expiration cycle trade or position. So, while it's definitely dangerous to get involved in broken stocks, if you choose to do so, you might as well sell the names that offer some high premiums as a way to reduce your risk and boost your return. Steve Following your strategy for butterflies or sideways markets, here is my current position. ... I want to recover my past losses by following your trick. ... Am I doing this correctly? -- K Without revealing all that happened behind the curtain, this reader did in fact establish an attractive butterfly spread as per the
sideways market article , and he looks poised to profit. And while I'm flattered he followed my suggestion, I don't think we should refer to trading strategies as "tricks." That's what magicians do, and I don't want our final act to be making our money disappear.