Get on Base with SPY Covered Calls

David Eckstein is my favorite baseball player. At 5'-7", the Arizona Diamondback shortstop is one of those methodical hitters who just wear down pitchers by going deep in the count, fouling off balls, and getting base-hits by hitting shots just over the head of second basemen and just beyond the reach of short-stops or sometimes bunting. He only had two home-runs the entire 2008 season but his on-base percentage was one of the best in the league.

I've been thinking of a strategy for writing deep in-the-money covered calls on the S&P 500 ETF (SPY) that reminds me of the way David Eckstein approaches hitting. Here's the idea. Buy 100 shares of SPY at around $88 as the underlying for an $8,800 investment. Use the buy-write feature that most retail brokers offer to sell a January 84 call for around $700 at the same time.

Here's the math. If SPY settles above $84 on the third Friday in January, your call will most likely be exercised and your 100 shares sold for $8,4000. Your net position is only $8,100 when you factor in the call that you sold however so your gain is $300 or about 3.5%. Not bad for a one month trade.

If SPY settles below $84 on the third Friday in January, your call will most likely expire and you will still have your 100 shares and you keep the $700 premium. Say it's a really bad month and SPY drops 10% to $80. If you were merely long the SPY at $88, your unrealized loss would be $800, but since you sold a covered call for $700, you've hedged yourself against the down-side and your net loss is only $100.

If volatility sticks around for awhile, options premiums will remain high and you could potentially repeat this strategy every month. This is far from a home-run play but sometimes just getting on base and methodically advancing runners is the best way to stay in the game.

Disclosure: Author holds a long position in SPY

Comments

[cyclingscholar:]

Research has shown that the BEST overall combination of option INCOME and hedging is accomplished when the option strike price is very close to the stock price....i.e. at the money or slightly out of the money. If you write an $84 while the 'stock' is at $87 you have basically turned $3 of capital into current income, fully taxable as ordinary income, silly rabbit!

Write the call at or just slightly out of the money.

cyclingscholar

2008 Dec 22 07:08 AM

[sr9web:]

cyclingscholar - thanks for the tip!

2008 Dec 22 01:58 PM

[doylegroup:]

In todays mrk I totally agrre with the author. Yes cyclingscholar you are buying capital..but with the volitility today in the money calls "hedge" downside risk more effrctively. When vols return to the average then I would agree sell at or slightly out of the money options. IMHO

2008 Dec 22 05:36 PM

[Alex F.:]

Why would you make two trades and pay double the commissions and splippage when you can achieve exactly the same thing with a simple short 84 put!?

2008 Dec 23 04:46 AM

[Fred Thomson:]

This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all but the strongest bull markets. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at coveredcallcalculator....

Jan 02 03:21 PM