We’ve all been there. We have all sold a covered call against a stock that we own and have been initially excited about the premium that we collected.  The premium may have been as high as 1% for only 1 month.  How exciting it is when you get that much guaranteed money (with the obligation to sell the stock if called upon to do so by the way) in that short of a period of time.  After all, if you can do that every month for a year, that comes out to a 12% rate of return.  On top of that, as if life couldn’t possibly get any better, the stock doesn’t even have to move to achieve such a result.  My goodness, the rest of the world is so stupid for not doing this all the time.

Of course, I’m being a bit over-dramatic with the first paragraph.  Let’s look at the other side of this coin.  You sell a covered call, and the stock goes above your short strike price.  At first, you feel excited.  After all, you’ve achieved the price that the trade can get the maximum profit.  All you have to do now is wait until expiration and your obligation will be fulfilled and you can move on with your life.  Did I mention you will be moving on with the maximum profit?  That just feels good to hear.

However, there is one problem.  There are another 28 days until expiration for this covered call.  At first, you feel like it is fine.  After all, good things come to those who wait.  However, you then see the stock go up another dollar in value.  Granted, you did get $3 for the covered call (totally made up number by the way), so the fact that the stock is only $1 in the money doesn’t make you feel bad.  After all, you are still going to be ahead of where the stock would have been had you simply owned the stock.  Yes, the rest of the world is still behind you, because you sold a covered call.  You were smart.

Then a few more weeks pass, and the stock continues to increase.  In fact, the stock is now $7 in the money.  By selling the covered call, you only got about half the profit that you could have compared to simply owning the stock.  And to make matters worse, you have to wait another 12 days until expiration Friday to fulfill your obligation.  You even try to avoid all of the friends you told about your brilliant idea because now you feel stupid.  You can hardly wait until expiration is done and you can move on.

If you haven’t had those feelings, you’ve never sold a covered call before.  Yes, any experienced covered call trader will tell you that it is good to get called away.  However, the emotional pain that goes with that can be overwhelming.  So, what can be done?  A call spread……

Let’s say that XYZ stock is trading around $53/share.  If you want to sell the 55 covered call on it, you can get $2 for a month.  However, if the stock rallies to $88/share, you will miss most of the rally.  Yes, you could try to roll up the call or something along those lines, but it is pretty difficult to do.  So, a strategy that we have been doing for a while is selling a call spread. 

Instead of selling a 55 call, we would sell a 55/60 call spread for $1.  Yes, there is less premium to take in, but you have unlimited upside past 60.  By using some of the premium taken in from selling the 55 call, you can buy the 60 call.  The net overall credit is $1. 

Since there are times that we sell covered calls and there are times that we sell spreads, I’d like to go through the main advantage and disadvantage of the call spread vs. the covered call.

The advantage of selling the call spread is that you will get unlimited upside should the stock run through the short strike.  You will not have to worry about missing out on the next big thing if the stock runs up.  The only disadvantage is that you will collect less premium.  That’s it. 

So, the question to ask yourself is are you willing to take in less premium to have some upside opportunity?  If the answer is yes, than this may be a trading tool to add to your trading toolbox.

For more information on how I help people as a financial advisor, email me at mtosaw@stcharleswealth.com.  Follow me on Twitter @MikeTosaw.