March 16, 2003

Covered calls vs. call spreads
By John Brasher, CallWriter Publisher

While there are many difference between covered writes and call spreads, the largest one is the ease of making money with them! It is much easier to make money consistently from covered calls than spreads, and to keep losers few and small, because covered call writers don't have to be nearly as good at picking direction and getting the timing right as spread writers do.

Covered calls are simple - buy the stock, sell call options (calls) on the shares and pocket the premium, then sell the shares to finalize the profit - too simple for some. In an option spread you buy one call and sell another call (or buy a put and sell another put), each with a different strike price. The "spread" is the difference between the two strike prices. In credit spreads (bear call and bull put), the trade generates a credit to you going in, but you are at risk for the total spread, which is the difference between the two strikes, less the credit received. In debit spreads, (bull call and bear put), the trade creates a debit going in, but you stand to make the amount of the net spread. A calendar spread is one in which you sell a call or put for one month and buy a call or put even further out.

In fact, many traders find covered calls downright boring and are attracted to the action of option spreads. We don't find 3% to 5% monthly returns (36% to 60% annually) from covered call writing to be boring, but that's beside the point! The point is, how do they compare?

The answer to the question of covered calls vs. option spreads ultimately depends on several things, principally your perspective and taste for adventure. Option spreads can create large profits but also large losses. You must be an excellent technical analyst, however, to make consistent money in spreads and should have an excellent understanding of market dynamics. When the stock moves overnight against a spread position, there is no way to get out of the spread until the next trading day. You can only hope the stock pulls back before expiration and gives you a chance to ameliorate the loss.

Here is an example of the problem: if you had a short $35/long $40 bear call spread on Sepracor (SEPR) in the March cycle when SEPR was $28, you would have gotten badly hurt, because it gapped up $10 overnight to put the spread underwater.

Spreads can pose considerable danger for investors, especially investors who lack trading experience and even more especially for those who lack trade management experience. If the stock moves adversely to you, spreads are almost impossible to fix, either because the options become worthless, or because the cost to buy back the short option rises dramatically. In debit spreads, the debit is the maximum loss, but a loss of 100% is still a huge loss! If that is not bad enough, implied volatility can evaporate, leaving the trader with options worth very little, so that no action (except an Act of God) can save the trade.

Calendar spreads do little to diminish the risk inherent to spreads. First, a gapping stock can catch a calendar trader just like any other.

Example: buy the July 35 on a $28 stock and begin selling $30 calls against it each month. If the stock moves above $28 the trade is in trouble, and a move (or worse, a gap) above $35 would hand the trader a good spanking.

Second, if the market moves away from the long calendar option that you’re selling options against, you have to clear the long calendar at a loss.

In the above example, if the stock drops to $25, or $20, how profitable will it be to sell options against a long 35 call? The farther out a calendar is bought, the greater the likelihood of a price move making the long calendar irrelevant or painful.

Third, if a trader buys a calendar at a point of high implied volatility to sell other options against it, he is in trouble if volatility implodes, because the premiums from selling options every month against the calendar will collapse, obviating the very reason he or she got into the trade.

And there's one more thing about spreads: if the trade moves against you, it is always possible to wait for a pullback or advance to remedy the situation, and these do happen. But remember that when your short option has become an ITM option, you are always at risk of being called out and cementing the loss in place permanently.

I’m not knocking spreads, because we understand them and like them a lot, in their proper place and in the right situation. But all spreads – calendars especially - require a specialized approach to be traded successfully. Trading options is not like trading stock; the dynamic is very different. I also am aware that this discussion is highly simplified. But nothing changes the fact that, while spreads offer far higher returns than covered call writing, the option spread still is a limited return strategy in which you can easily lose 50% to 100% of the amount at risk.

Now, let’s talk about covered calls. A stock can do 5 things before option expiration:

1.  Move up significantly
2.  Move up slightly
3.  Move very little (essentially hold its price)
4.  Move down slightly
5.  Move down significantly

Covered calls win, or worse case break even, in all these movements except #5, but it is usually possible through trade management to greatly suppress losses even in the #5 situation. Our trade picks were winning approximately 80% of the time during 2001 - 2002, when the market was lousy, because we made a lot of deeply in the money picks.

Spread traders would argue that OTM bull put spreads win in all five directions but #5, and that OTM bear call spreads win in all but #1. That is true, but the risk in these credit spreads is very high compared to the net credit pocketed. But all other credit spreads and all debit spreads win only if the stock makes the necessary price move and does it before expiration. Time is on the covered call writer's side but - except in OTM credit spreads - is not on the spread trader's side.  So you have to ask yourself... in addition to all the other risks you take in trading, do you want to add time to the list?

We’ve learned that people trade in ways that match their personalities. Straight options trading can yield huge profits and huge losses. Traders who like more "action" tend to prefer straight option trades, or even just buying calls and puts, to covered calls. My own observation is that traders do better mastering covered call writing first, because so many of its lessons transfer directly to options trading. Put differently, anyone who can’t consistently win at covered call writing has no business trading option spreads.

Once a covered call writer develops a solid trading record and decides to spread his or er wings, the most profitable thing to do – by far - is sell naked puts and naked calls. If a trader is sharp enough to win consistently at option spreads, naked writing is vastly more profitable, and while naked writing poses huge risks theoretically, in reality the risk is usually very manageable.

But covered call writing can easily produce 36% to 60% a year without using margin or rolling profits into new trades. More aggressive traders who keep all their profits in the market and use margin can actually double their trading capital in a year. No kidding.

Can spread writers do better? The really good traders who are always in the market can, but few casual traders can do better with spreads.

Consistent trading success is what CallWriter is all about. We not only show you the fattest trades, we teach you how to analyze them and pick the ones with the highest combination of return and safety. We also show you how to manage your trades after you run them for maximum profitability. We hope you've enjoyed our newsletter!

Good luck and good trading!