Key Point The fact that you are creating the covered call
strategy (buy-write) by doing the vertical spread is very
important to note. For margin purposes, the vertical spread will
be margined at a much more favorable rate than the traditional
buy-write because you do not own the actual stock and therefore
do not have as much to lose. This is especially important to
investors/traders who trade on margin.
This scenario includes another significant value added benefit
that you receive. When you purchase a spread, the most you can
lose is the amount you paid for the spread which in this case is
$10.15.
As you already know, the biggest risk in a covered
call/buy-write strategy is a large downward move in the stock.
If you had done this trade with the actual stock and the stock
traded all the way down to $20.00 from $60.00 (although
unlikely) we would stand to lose almost $40,000.
However, if you did the trade with the 47.5 calls in place of
the stock via the vertical call spread above, the maximum loss
is what you spent on the trade. Remember, you purchased the
vertical call spread for $10.15. If you traded the spread an
equivalent amount of times to equal 1000 shares, you would have
bought a total of 10 spreads.
The total dollar amount of your investment would be $10,150.00,
as opposed to $58,900 had you bought 1000 shares of Amgen
outright. Your loss will be maximized at $10,150 if the stock
traded down to $20.00 as opposed to a $38,900.00 loss in the
case of outright stock ownership. Even if the stock was to trade
down to $0, your maximum possible loss would still be $10,150.
This is because once the stock gets below $47.50, the December
47.5 calls become worthless thus the calls can not lose any more
money no matter how much more the stock trades down.
In order to continue or roll this position, you will have to
roll two options into the next month instead of one. In a
traditionally structured covered call strategy (long stock,
short call), you are dealing with only one option series.
However, in the stock replacement strategy, you have a second
option series (the call you purchased to replace the stock) to
roll into the next month. This may incur an additional
commission but the trade is obviously well worth it when you
look at the previously stated risk/reward scenario and the size
of the capital outlay needed to initiate the position.
Conclusion: As we detailed here, the stock replacement version
of the covered call/buy-write strategy is an example of the
proper use of option leverage. It offers the investor a bigger
percentage return, less risk and less capital requirement than
the traditional covered call/buy-write strategy.
Anytime you are interested in a high dollar stock, first look to
see if there are any deep in-the-money calls that fit this
replacement scenario and evaluate if this might be a better
option. |
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