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In a late September article titled, "Covered Calls for Income Can Cost Dearly in Long Term Gains", I made it clear how writing calls against a portfolio of high quality shares can significantly penalize the investor in the long run, for three primary reasons:

  • Stocks that rise sharply in price are called away, leaving the writer with only modest gains
  • Stocks that fall sharply in price remain in the portfolio, with only modest premiums to offset the big losses
  • Attempts to recapture some gains in the latter case by writing options at lower strikes denies the investor the possibility of a strong rebound

The cumulative effect, as I said in the article, is that "your peak performers get called away, and your dogs get to be a larger and larger part of the kennel."

I am grateful for the many comments and suggestions that readers gave me about the article. The improvements option traders suggested tended to fall into two categories:

  1. Write the calls more "out of the money" if you feel the need to capture some gains
  2. Write calls on only a portion of stock holdings

While these techniques have some positive effects, they merely introduce new shortcomings into the strategy. In the first case, you have even less income to offset big losses; and in the second case, your portfolio continues to get smaller and smaller as fractions of your holdings get called away. Also in the second case, you have fewer shares to write calls against with each successive cycle.

This led me to think of an entirely new options strategy, which I will designate as "Covered Spreads." Specifically, covered Vertical Credit Spreads. Options traders know that a vertical credit spread occurs when you sell, or write, an option at a low strike price and buy an option at a higher strike price. Consider the SPDR S&P500 Trust Series ETF (NYSEARCA:SPY) as an example. As I write this, with the ETF just shy of $141.00 a share, a typical credit spread might be:

  • Write, or sell, 10 November 142 calls at $2.00
  • Buy 10 November 143 calls at $1.47

This generates income at $53 for each pair of calls sold, so for the 10 pairs, you generate $530, minus commissions.

What if an investor who owned 1000 shares of SPY wrote this credit spread? Since he owns the shares, it is a "covered spread." How is this better than a simple covered call strategy?

First, consider the case where the SPY advances sharply, say to $147 a share by the expiration date in mid-November. There have been several months over the past year where SPY has gained this much -- June, for example. In the case of the covered call, the ETF gets called away at $142, plus $2 worth of premium income, for a total gain of $3.00.

The investor no longer owns SPY and, if you are to continue writing covered calls, you must repurchase the shares at $147, considerably higher than you just sold them.

With the covered spread, the results are much more pleasant. The ETF gets called away at $142, but you buy it right back for $143 (since you own options at that strike price). You still own it at $147. The final result?

  • You have gained $5 of the $6 dollar price advance: $141 to 147 is $6 dollars, and you lost $1 between the strike prices.
  • You also have your $0.53 gain on the spread. So combined, you received $5.00 + $0.53 or almost all of the six dollar increase in the value of the shares. You left very little on the table.
  • You still have the shares, so you can repeat the strategy for the December cycle.

Another way of looking at the covered spread strategy in this example is to say: you have traded away $1000 of your potential capital gains in exchange for about $500 in premium income. Compare this with the simple covered call strategy, where you trade away all of your gains above the strike price in exchange for somewhat higher premiums.

Now consider the opposite scenario, where the market falls sharply. Using the same strike and premium prices as above, imagine the ETF falls to $135 a share. This $6 loss:

  • Is offset by $2.00 premium for the simple covered call
  • Is offset by $0.53 for the covered spread

At first, the covered call strategy looks superior. But is it? On the next options cycle, the covered call writer will have to write an option at a strike price of $136 or so in order to gain another $2.00 in income like he did the previous month. If he does so, he again leaves a lot on the table if the market rebounds sharply -- you are basically back to scenario #1 in this case.

In contrast, the covered spread writer can write a spread at say, 136-137, pocket a similar premium to the month before, and know that he will capture most, if by no means all, of any rebound. This is a very strong second advantage to a covered spread strategy -- it gives your portfolio a chance to recover.

In the third scenario, where the market stays flat, the covered call strategy is indeed superior. $2.00 in income beats $0.57 under any accounting system I am familiar with! But there is still one stickler that makes the covered spread strategy attractive, even in this latter case.

A crucial variable in determining the price of an option is its implied volatility -- the guesstimate traders make as to how volatile the market will be in the near future when they buy the option. Implied volatility for stocks and ETFs varies widely over time. Look at this chart of implied volatility for SPY:

(click image to enlarge)

As implied volatility varies, so will your monthly income under a pure covered call strategy. In fact, as I mentioned in my previous article, it is the collapse in implied volatility in recent quarters which has decimated the returns (and hedging effectiveness) of covered call portfolios.

With a covered spread, however this effect is far less noticeable. Since you are writing a call and buying a call at the same time, the effects cancel out in large part. For investors relying on predictable income on a monthly budget cycle, this is critical.

Thus, my analysis suggests that a covered spread strategy would be superior to a covered call strategy for those investors still desirous of long-term gains in addition to predictable income.

Tomorrow, I will submit an article showing the monthly results of such a strategy that I have followed using the SPY ETF since February of 2012.

Source: Improving Covered Call Returns By Using Covered Vertical Credit Spreads

Additional disclosure: I use covered spreads (and covered calls, sometimes) to supplement my income from dividends paid by the ETFs that I hold.