Mon Apr 24, 2006: Sell Call Spreads Instead of Covered Puts?

Covered put option writers seek to profit from the underlying stock either staying flat or going down. Their risk is that the stock can go up.

Call option credit spread writers face the same profit or loss scenario. They make money if the stock stays flat or goes down, and can lose money if it goes up.

The difference is in the details, some of which we will look at next.

In general the major difference is that percentage gains or losses on invested principal are usually higher for spread writers because the leverage (and thus the percentage risk) is greater, for the price range near the strike prices.

Let's consider the stock of Broadwing (NASDAQ-BWNG), currently priced at $13.23 per share. May 12.50-strike covered puts, which expire in less than four weeks, can be sold for 0.75, which is $75 each. The margin to sell short 100 shares of BWNG is $662.

The return on the covered put assuming the stock finishes unchanged at 13.23 on May 19 is $75 divided by the investment of $662, or 11.3%.

If the short stock finishes below 12.50 it will be put back to you (thus automatically closing out your short position) for an additional profit of $73 no matter how low it goes.

Please remember we're ignoring commission costs at the moment. Commission costs will reduce your net returns.

If the stock goes up, the $75 profit will be reduced by $1 per penny the stock rises, because you are short 100 shares, such that at (13.23 + 0.75) = 13.98 the position will be at breakeven. It will turn into a loss of $100 per full point if the stock rises further.

A call credit spread could be sold instead. This would involve simultaneously writing (selling) a May 15 call and buying a May 17.50 call. At current prices this can be done for a net income of 0.45 or $45 per spread.

The margin requirement for putting on this position is the width of the spread minus the premium received, in this case $250 - $45 or $205 margin required. The net return if BWNG stock finishes unchanged is $45 / $205 = 22.0%. 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 15.00 the result is also the same.

Above 15.00, the upside risk comes into play. The 15.00 call you sold will have value equal to $100 for every point above 15.00. The 17.50 call you bought will be worthless unless the stock is above 17.50. Actually it would have some time value before it expires but for now we are only considering what happens at expiration.

Between 15.00 and 17.50, your call will be worthless and the call you sold will cost you $100 per point to buy back, with a maximum of $250 if it finishes in-the-money by 2.5 points at a price of 17.50.

Above 17.50, your net repurchase cost would still be limited to $250 because although the 15.00 call would be worth an additional $100 for each point up, your 17.50 call would also gain that much, offsetting the loss on the 15.00 call point-for-point no matter how high the stock finishes. So your maximum loss would be $205 because you received $45 income up front and have to pay off $250 net to close out the spread.

To close out the spread you would buy back the 15.00 call and then sell your 17.50 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 $250 to close it out if the stock is above 17.50. This is because of the difference in the marketplace between bid and ask prices. Typically you might end up having to pay approximately $270 plus commissions.

If you sell your 17.50 call before buying back the 15.00 call then the 15.00 call will be naked, subjecting you to a possible margin call as well as theoretical risk of unlimited loss should BWNG stock keep going up.

If the stock finishes between 15.00 and 17.50 you will still have to buy back the 15.00 call to close out your spread even though the 17.50 call you owned expired worthless. The repurchase cost to close it out will be approximately $100 for every point above 15.00, plus slippage and commissions.

If you do not buy back the 15.00 call and the stock finishes above 15.00 you will be "assigned" on your short call. The owner will exercise his or her right to "call" (buy) 100 shares of BWNG from you at 15.00. Even if the current market price is much higher you will still be forced to automatically sell it short in your account at $15.00 per share. In that case you would still get to keep the $45 and possibly also be able to sell your 17.50 call before it expires.

So as you can begin to see, selling call spreads can involve more complexity than selling covered puts. There are further risks not covered here, such as the possibility of early assignment if the stock rises into the money before expiration, and forced buyback if you are assigned to sell short but there are no shares available for shorting. Please ask your financial advisor about these additional risks. I will try to explain some of them more fully in future commentaries. The point of this article was to compare covered put writing with call credit spread writing. For now I'll summarize the comparison as follows:

If the stock goes down you can make more money with the covered put strategy, depending on how far the put strike price is below the current stock price.

If it remains unchanged you can earn a superior percentage return by selling call spreads.

If it goes up your risk of loss is limited to your margin deposit with call spreads, while with covered puts your risk of loss is unlimited.

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