Bull Call Spread An Alternative to the Covered Call

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Bull Call Spread: An Alternative to the Covered Call

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

Since the objective of writing covered calls is to earn premiums, it makes sense to sell near-month options as time decay is at its greatest for these options. Hence, the two strategies that we are comparing will involve selling near-month slightly out-of-the-money call options.

Example

Suppose we have a stock XYZ currently trading at $50 in June and the JUL 55 call is priced at $2 while a JUL 45 call is priced at $5.50.

Investor A enters a bull call spread by buying the JUL 45 call while selling the JUL 55 call. His upfront investment is $550 (long call) – $200 (short call) = $350.

Investor B does a covered write by buying 100 shares of XYZ at $50 each and selling a JUL 55 call. His upfront investment is $5000 (long stock) – $200 (short call) = $4800.

The table below shows their profit/loss at various stock price on expiration date.

Strategy Upfront Investment Stock Price on Expiration Date
Below $45 $45 $50 $55 & Above
Bull Call Spread $350 -$350 -$350 +$150 +$650
Covered Call $4800 Unlimited -$300 +$200 +$700

As can be seen, the maximum potential profit for the bull call spread is only slightly lesser than the covered call but the covered call has a potentially unlimited downside risk (all the way up to $4800 in potential losses).

Hence, the bull call spread is clearly a superior strategy to the covered call if the investor is willing to sacrifice some profits in return for higher leverage and significantly greater downside protection.

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Bull Call Spread: An Alternative to the Covered Call

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Smart Money

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, 2020

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.

Why I Prefer the Bull Call Spread Instead of Covered Call

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