Logan Ramasamy's Stock Weblog

Writing (selling) covered calls in one of the most basic and also the
safest of all option strategies. You can generate additional income from
stocks that you own, and this income helps hedge against the risk of
owning the stocks.

But in order to write a covered call, you must first own at least 100
shares of the underlying stock. This can develop into a large
out-of-pocket expense.

However, as with all option strategies, there are ways to produce
returns without large cash outlays. Naturally, the trade-off for this is
that you will take on more risk. If you are comfortable with that, and
consider yourself a nimble trader, here is a twist you can apply.

The twist is to write a call credit spread. A call credit spread is a
bearish tactic that pays off full profits if the underlying stock price
stays the same or declines.

To open a call credit spread, you buy a call at the next strike price
with the same expiration date above the call you write. The call you buy
acts as a purchase order for the stock in the event you are assigned
the call you write.

For example, General Electric (GE) is a stock that has undergone some
recent weakness. If you believe this weakness will continue through the
rest of this year, you can profit from this by opening a call credit
spread.

To do this, you would sell the GE Dec 35 Call and buy the GE Dec 37.5
Call, to generate an income of .6 point ($60, the bid price of the 35
call minus the ask price of the 37.5 call) at current prices.

This may not sound like much, but you are generating the $60 against a
$250 margin requirement (strike price of the option you buy minus the
strike price of the option you sell), which is a 24% return for a
four-month holding period.

If the 35 Call goes in the money and you are assigned, you must sell
100 shares of the stock at 35 for each contract you wrote. If you already
owned the stock as you would with a standard covered call you would
simply sell those shares and pocket your profit.

But with a call credit spread, you do not own the stock. You must use
the 37.5 call to buy the stock at 37.5 to meet your obligation. So
instead of a profit, you are at risk of a loss. The maximum loss you can
incur is the amount of the spread minus the net income you received ($250
minus $60 = $190 in our example) per contract.

Writing (selling) covered calls in one of the most basic and also the
safest of all option strategies. You can generate additional income from
stocks that you own, and this income helps hedge against the risk of
owning the stocks.

But in order to write a covered call, you must first own at least 100
shares of the underlying stock. This can develop into a large
out-of-pocket expense.

However, as with all option strategies, there are ways to produce
returns without large cash outlays. Naturally, the trade-off for this is
that you will take on more risk. If you are comfortable with that, and
consider yourself a nimble trader, here is a twist you can apply.

The twist is to write a call credit spread. A call credit spread is a
bearish tactic that pays off full profits if the underlying stock price
stays the same or declines.

To open a call credit spread, you buy a call at the next strike price
with the same expiration date above the call you write. The call you buy
acts as a purchase order for the stock in the event you are assigned
the call you write.

For example, General Electric (GE) is a stock that has undergone some
recent weakness. If you believe this weakness will continue through the
rest of this year, you can profit from this by opening a call credit
spread.

To do this, you would sell the GE Dec 35 Call and buy the GE Dec 37.5
Call, to generate an income of .6 point ($60, the bid price of the 35
call minus the ask price of the 37.5 call) at current prices.

This may not sound like much, but you are generating the $60 against a
$250 margin requirement (strike price of the option you buy minus the
strike price of the option you sell), which is a 24% return for a
four-month holding period.

If the 35 Call goes in the money and you are assigned, you must sell
100 shares of the stock at 35 for each contract you wrote. If you already
owned the stock as you would with a standard covered call you would
simply sell those shares and pocket your profit.

But with a call credit spread, you do not own the stock. You must use
the 37.5 call to buy the stock at 37.5 to meet your obligation. So
instead of a profit, you are at risk of a loss. The maximum loss you can
incur is the amount of the spread minus the net income you received ($250
minus $60 = $190 in our example) per contract.

That is the disadvantage of a call credit spread. With a standard
covered call your loss on an assignment is only an “opportunity loss,” in
that you do not participate in rallies by the stock beyond the strike
price of your covered call. With a call credit spread, your loss is an
actual out-of-pocket loss.

To guard against this you can “buy back” the option you wrote, which
removes your obligation to deliver 100 shares of the stock. But you will
likely incur a loss from this, also.

This risk of loss if the stock price rises makes a call credit spread
strictly a bearish strategy.

The advantage of a call credit spread is that you can profit from a
neutral or bearish stock without making any cash outlay. Also, your risk
is clearly defined (no more than the amount of the spread).