Bull Call Spread: An Alternative to the Covered Call

call-spread

Most new option traders start with a covered call strategy. You buy 100 shares of company xyz and you sell one option that has a near month expiry date. One objective of this strategy is to earn extra income from the option premiums which hopefully expires worthless. Short term options decline in value very quickly if the stock price remains fairly flat or falls a little in value.

The covered call strategy is limited by the amount of capital you have to invest. Many popular stocks are trading over $100 like Apple ($114.90), Netflix ($123.75) and Facebook ($119.40) so buying 100 shares of these three companies would require about $35,805 of your capital.

An alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. Instead of buying the underlying stock in the covered call strategy, the bull call spread strategy requires the investor to buy deep-in-the-money call options instead.

To illustrate the difference, I am going to select 3 bull call spreads for the above three popular stocks. Disclaimer: These trades are for educational purposes only and are not recommendations.

Quotes as of 10:00 a.m. on Dec 13, 2016

Example #1

Buy 100 shares of Apple at $114.90 sell one call option Jan 20 at $115.00 for $2.60

Call spread: Buy 1 Jan 20 $105 call for $10.45 – sell one call Jan 20 at 115.00 for 2.60

Example #2

Buy 100 shares of Netflix for 123.75 – sell Jan 20 call at $130 for $4.50

Call spread: Buy one Jan $120 for $9.15 – sell Jan 20 call at $130 for $4.50

Example #3

Buy 100 shares of Facebook for$119.40 – sell Jan 20 call at $120 for $3.10

Call spread: Buy one Jan 20 $110 for $10.45 – sell Jan 20 call at $120 for $3.10

Now, the capital required to purchase 100 shares of each of these three stocks is $35,805 minus $1020.00 from selling the covered call options equals $34, 785. The bull call spreads requires a total outlay of $3,005 minus $1020.00 from selling the exact same covered calls equals $ $1985.00

Only time will time if these bull call spreads are good, bad or ugly. Stay tune for a follow-up post in the new year.

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8 thoughts on “Bull Call Spread: An Alternative to the Covered Call

  1. So for Example 1 your net premium cost is $2.60 – $10.45 = -$7.85, which means your breakeven price is $112.85 ($105 ITM call + premium paid), which is only 1.8% below the hypothetical purchase price of $114.90.

    I would argue that the possibility of this ending up “bad” or “ugly” (i.e. losing real money) is pretty high.

    Let’s say that shares close at $112 on January 20, which is well within the realm of reasonably expected outcomes.

    In this case, the bull call spread loses $85 of real legal tender (your long call has $7 of intrinsic value at expiry and your short call is worthless…this, of course, completely ignores commission, exercise and margin costs).

    If you were to have done the buy/write with a cost basis of $114.90 you will have lost $290 of imaginary cost basis bucks, but made $260 of real legal tender. So you would have “lost” $30 of arguably imaginary money.

    And you would still own 100 shares of one of the biggest and most successful corporations in the world (which will pay you $228/year in dividends BTW).

    I realize the point of this exercise is to reduce the capital outlay and still achieve a similar profit potential.

    But that similar profit potential comes at the cost of a completely different “loss potential”, which is worth pointing out I think.

    Liked by 2 people

    • Thanks Catfishwizard for your comments. I thought about pointing out the loss potential on all three examples but it would have been an extra long post. I plan on a follow up post based on actual price movements. Plus, as an educational type post and not actual trades, I wanted the readers to do some math on their own.

      Like

  2. I do follow catfish:
    The downside seems to be that at expire you can loose everything you put in. When the stock drops below the long call, you end up empty handed. With the covered call, you would still have the stock. Not sure this is better… It assumes the stock will recover one day.

    Like

    • So true but it is also true that the downside could continue on these stocks. My loss is limited to just under $2,000 plus I could still own the stock if it is trading above the call strike price. The potential gain on my investment is 30% but I agree that my potential loss could be 100%

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      • For now, I have not yet used this strategy. I am dipping my toes in the water with covered strangles? With stock I want in my dividend portfolio. I would have bought the stock anyway. I see covered strangles as a potential yield booster. i still have to figure out how I will react when called away!

        Liked by 1 person

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