Tue Mar 13, 2007: Selling Call Spreads (RIMM)

Let's consider a bearish option writing strategy on the stock of Research in Motion (NASDAQ-RIMM), currently priced at $134.34 per share.

An April 150-155 call credit spread on RIMM could be sold for a net credit of 0.95, which is $95 per spread. This would involve simultaneously writing (selling) an April 150 call and buying an April 155 call.

The margin requirement for putting on this position is the width of the spread minus the premium received, in this case $500 - $95 or $405 margin required. The net return if RIMM stock finishes unchanged is $95 / $405 = 23.5% excluding commissions, not bad for one month. Both call options would simply expire worthless.

If the stock goes down the result is the same.

If the stock goes up but stays below 150 the result is also the same.

Above 150, the upside risk comes into play. The 150 call you sold will have value equal to $100 for every point above 150. The 155 call you bought will be worthless unless the stock is above 155. Actually it would have some time value before it expires but for now we are only considering what happens at expiration.

Between 150 and 155, your call will be worthless and the call you sold will cost you $100 per point to buy back, with a maximum of $500 if it finishes in-the-money by 5 points at a price of 155.

Above 155, your net repurchase cost would still be limited to $500 because although the 150 call would be worth an additional $100 for each point up, your 155 call would also gain that much, offsetting the loss on the 150 call point-for-point no matter how high the stock finishes. So your maximum loss would be $405 because you received $95 income up front and have to pay off $500 net to close out the spread.

To close out the spread you would buy back the 150 call and then sell your 155 call.

In addition to having to pay another round of commissions when you close out a spread, you will also have to pay "slippage" which means that your net cost will actually be more than $500 to close it out if the stock is above 155. This is because of the difference in the marketplace between bid and ask prices. Typically you might end up having to pay approximately $520 plus commissions.

If you sell your 155 call before buying back the 150 call then the 150 call will be naked, subjecting you to a possible margin call as well as theoretical risk of unlimited loss should RIMM stock keep going up.

If the stock finishes between 150 and 155 you will still have to buy back the 150 call to close out your spread even though the 155 call you owned expired worthless. The repurchase cost to close it out will be approximately $100 for every point above 150, plus slippage and commissions.

If you do not buy back the 150 call and the stock finishes above 150 you will be "assigned" on your short call. The owner will exercise his or her right to "call" (buy) 100 shares of RIMM from you at 150. Even if the current market price is much higher you will still be forced to automatically sell it short in your account at $150 per share. In that case you would still get to keep the $95 and possibly also be able to sell your 155 call before it expires.

Until next time, best of luck with your option investments!