6A: Covered Call Alternative

Credit Call Spread

INCOME STRATEGY

The Credit Call Spread is typically seen as an income generating options strategy used by somewhat bearish investors who have no intention of owning the underlying stock and want to define risk versus selling an outright naked Call. The long Call leg provides protection against a sharp move upwards in the underlying stock and/or us finding ourselves unintentionally short the stock (from having our short Call assigned).

This said, in our general overview, we approached the Credit Call Spread from the perspective of its commonalities with a Covered Call. So, can a Credit Call Spread actually make for a smart alternative to a Covered Call?

At Options AI, we do see scenarios where this might be the case and where a savvy investor may want to contemplate using a Credit Call Spread.

Worry less about missing big moves or getting called away

As we know, with a Covered Call, all potential gains in the underlying stock are capped at our breakeven level. Therefore, if we are selling a 42 strike Call at $0.50 against 100 shares for example, our upside potential in the underlying stock is capped at $42.50. If the stock price is above our 42 strike at expiration, we incur the risk of being assigned (forced to sell our stock at $42) if we do not buy-back our short Call at the prevailing market price.

But let’s say we’ve instead sold a 42/44 Credit Call Spread at $0.40 against our 100 shares of stock. Here, we know that our higher strike long Call defines our risk. So, should the underlying stock be subject to an outsized move upwards, we get to participate again in those stock gains above $44. Put simply, we have traded $0.10 less income for the ability to participate in a large upwards move in the stock, while at the same time reducing the risk of having our stock called away (since we can instead exercise our long Call to cover any assignment of our short Call).

In the example above we find that we can buy a Call only two strike levels higher than our short Call (42/44) to create a relatively narrow spread, while only forfeiting $0.10 in premium collected. This may not hold true when looking at more expensive options on stocks with higher implied volatility (IV). In this scenario, when using a Credit Call Spread as an alternative to a Covered Call, we may want to set our higher strike long Call significantly higher, so as to minimize the impact (the cost of our long Call) on our net premium collected. This said, the Credit Call Spread may still make for a smart alternative, since the higher IV itself implies greater potential for an outsize stock move.

When you don’t own 100 shares

A Covered Call by definition requires that an investor owns at least enough underlying shares to ‘cover’ the risk of being assigned in the short Call. So, for each options contract sold, we must own at least 100 shares in the underlying company or ETF. This makes the Covered Call a capital intensive strategy for investors who don’t already own 100 shares and puts it out of reach for many looking at higher priced stocks.

So, can the Credit Call Spread provide an opportunity for income when we don’t own 100 shares?

Since we have already covered that a Credit Call Spread is a strategy most typically utilized by bearish investors looking to collect income while owning no shares at all, the short answer is ‘yes’. However, at Options AI, we believe it to be worthy of a more detailed analysis, since it is a use case that may be frequently overlooked.

Let’s assume we own 50 shares of the underlying stock, currently trading at $41.08. If we sell a 42 strike Call, we are not ‘covered’ on 50 shares if the stock price moves up and through our strike at expiration. Our potential losses are therefore unlimited since we may end up actually being short 50 shares (if we are assigned). The Covered Call as a strategy is therefore not an option.

However, if we instead sell a 42/44 Credit Call Spread, we know that our risk is defined given our higher strike, long Call. Our maximum risk is $160 (spread width less premium collected) and our maximum gain is $40. It matters less if the stock moves up and through our higher strike at expiration since our potential losses are limited and we can also exercise our long Call in the event our short Call is assigned.

The key point here is that we are now able to view the income strategy in straightforward dollar and percentage terms, rather than be concerned with holding the equivalent number of underlying shares. When we write a 42 strike Covered Call at $0.50 with 100 shares of the underlying stock trading at $41.08, we are looking to collect $50 of income (or approx. 1.2% of the underlying stock value ($50 divided by $4,108)) if the stock price stays below $42 at expiration. When we open a 42/44 Credit Call Spread with 50 shares of the underlying stock trading at $41.08, we are looking to collect $40 of income (or approx. 1.9% of the underlying stock value ($40 divided by $2,054) if the stock price stays below $42 at expiration.

If this income amount is acceptable, then we have just a couple of final considerations to ensure a fair comparison of the 100 share Covered Call to the 50 share Credit Call Spread (aside from being clear that we are moving from a level 1 basic options trade to a level 3 multi-leg options spread). The primary one being that, in theory, all potential losses from our short Covered Call will be indeed be ‘covered’ by our long stock position. We are forfeiting upside potential but not exposing ourselves to potential losses. With our Credit Put Spread we know we have a maximum potential loss of $160. Since we own 50 shares of the underlying stock, this maximum potential loss is theoretically reduced by 50% (50/100) to $80, but we can still incur a loss. This said, unlike the Covered Call, we know we are also able to participate in stock gains above the higher strike in our spread.

Conclusion

When trading options in an individual margin account, the Credit Call Spread may present a smart alternative to a Covered Call when an investor is less convicted about a stock not moving sharply higher and/or when an investor owns less than 100 shares. This said, as with all strategy selection, an investor must closely evaluate the relative trade-offs and risks associated with either strategy.

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