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We’ve devoted a number of pieces in our options education series to the covered call strategy in its various forms and iterations, and today we’re going to add one more twist to the list.
It’s an initiative called the “deep-in-the-money bull call spread,” a variation of the simple bull call spread discussed in our piece on debit spreads. But as you’ll soon see, there’s a significant difference.
Components and Rationale for the Trade
Covered call writers, of course, have the option of taking the traditional path and buying 100 shares of the underlying security and selling a call against it.
In this variation, however, the trader simply substitutes a deep-in-the-money call option for the shares; everything else stays the same. In so doing, the resultant cash outlay and the trade’s profit/loss profile are significantly altered.
Let’s look at a real-life example to flesh out the details.
Here’s six months’ worth of chart for The Priceline Group (NASDAQ: PCLN):
With the stock moving sideways (blue lines), and your belief in the company’s prospects growing, you figure by late June that it’s a propitious time to employ a covered call strategy (green circle).
On the one hand, the covered call lowers your price per share for the stock – affording you a comfortable downside cushion should the current slide continue. And on the other hand, it offers you some good capital appreciation potential should the stock resume its rise over the next few months.
The only problem with implementing the strategy is the incredibly high cost of the shares. At a whopping $1,155 per Priceline share, you’d have to drop $115,500 just to cover the cost of the underlying stock! And even though the near month 1400 strike call is offering a fat $15 in premiums, the thought of ponying up that kind of cash is still a bit rich for you.
So you consider the deep-in-the-money call option instead, and – lo and behold – you see there’s an opportunity.
The six-month (December) deep-in-the-money 1050 call is now trading for $131, meaning you can initiate the long side of the trade for $13,100 instead of $115,500. What a savings!
The near month 1400 strike still represents the short side of the trade, so your cost to initiate is $11,600 ([$131 – $15] x 100).
Deep-in-the-Money Bull Call Spread vs. Traditional Covered Call
A look at the table below illustrates all the parameters of the deep-in-the-money bull call spread versus a traditional covered call at expiration.
The deep-in-the-money bull call spread clearly offers both limited upside and downside potential on the trade. You’ll neither earn as much nor lose as much as you would with a standard covered call.
But with an initial savings of roughly 90% off the traditional covered call’s cost, it’s hard to argue against it. Particularly when it offers the possibility of writing additional premium in the ensuing months.
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