AN OPTION FOR INCOME IN PLACE OF A LIMIT ORDER TO SELL STOCK
Assuming that you own at least 100 shares of an underlying stock, opening a short Call position at a strike price that you would otherwise place a Limit Sell Order, is an often overlooked strategy.
After all, if you are keen to take profits in a stock if its price reaches a certain level, why not get paid for doing it?
Put simply, if we are long 100 shares of a stock that is currently trading at $41.08 and we would be happy to sell the entire position if the stock reaches $42, we might consider selling to open a 42 strike Call, at let’s say, $0.50. If the stock is above $42 at expiration, our short Call will likely be assigned. We have effectively sold our stock at $42 while keeping the additional $50 in income.
It is important to note that assignment and particularly early assignment of an option is not guaranteed. In this example, the underlying stock price may reach or pass through $42 prior to expiration and we may not be assigned (sell the stock). Therefore, compared to a Limit Sell Order, a short Call strategy provides us with less certainty that we will actually sell our stock position. With this in mind, it may be a less suitable strategy for those with greater conviction over wanting to sell their underlying stock position
Credit Call Spread as a Limit Sell Order
We’ve seen how switching from a short Call to a Credit Call Spread can be a smart strategy in other circumstances, so can it apply here?
From our review of a Credit Call Spread as an alternative to a Covered Call, we saw how one benefit of using a Credit Call Spread is that we are able to re-participate in underlying stock gains when there is outsized move up and through our long Call strike. In other words, if we were were very wrong on our initial view, we have not forfeited all of our potential gains.
The same idea can apply here when looking at a Credit Call Spread as an alternative to a Limit Sell Order.
Using the example above, rather than simply sell a 42 strike Call at $0.50, we decide to simultaneously buy a 46 strike Call for $0.10 to open a 42/44 Credit Call Spread to receive a net premium of $40.
If the price of our underlying 100 shares of stock is between our strikes at expiration we will likely be assigned on our short 42 strike Call, while our long 44 Call will expire worthless. Therefore, we sell our stock at our target ‘limit price’ of 42 while also collecting $40 in income.
However, if the stock is sees an outsized upwards move to, let’s say, $46 we might regret having sold our stock at $42. With a Credit Call Spread against long stock, we know that we can re-participate in stock gains above our long strike. With the stock now at $46 at expiration, our long 44 Call is exercised and our short 42 Call is assigned, effectively canceling our ‘limit order to sell’. We must of course forfeit $1.60 of the move in the underlying stock (the maximum loss of the spread), but we still own the underlying stock position to now either hold or sell at the higher price.