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In Wednesday's article, Improving Covered Call Returns by Using Covered Vertical Credit Spreads, I defined a covered vertical spread as a traditional vertical spread plus ownership of the underlying shares. I suggested using the SPDR S&P500 ETF (SPY) as a trading vehicle.

I define a covered vertical spread as a traditional covered spread plus ownership of the underlying shares, or ETF in this case. For example an investor may

· Own 1000 shares of the SPDR S&P500 ETF. at $141 a share

· Write 10 $142 November calls for $2.00 each

· Buy 10 143 November calls for 1.40 each.

The investor pockets $.60 in income on 1000 shares, or $600. He has the shares to deliver in the event the ETF is selling for more than $142 at expiration; thus the name "covered spread."

I suggested a covered spread might have 3 compelling advantages over its simple covered call cousin.

1. If the market advances strongly, the investor leaves "less on the table" than a simple covered call.

2. If the SPY falls sharply, you can write a covered spread at the now lower price and still not sacrifice a lot if the shares rebound sharply.

3. The trade is volatility neutral, so the monthly income is more predictable than a simple covered call.

The one case when this strategy might not be satisfactory are when the monthly gains, or recoveries from losses, are modest. In that case the money left on the table (the difference between the strike prices) could be a very substantial portion of the modest gains. In addition the income is less because you purchased the higher strike option.

I tested this strategy with SPY starting February 2012 on a monthly cycle.

March 2012 cycle results:

Position: 2/21/2012

· Bought $700 shares of SPY at $136.47.

· Wrote 7 March 138 calls, bought 7 140 calls, net credit $0.72

The market fell sharply after this. I unwound the spread for a $0.19 debit. Total gain on the spread $0.53. SPY had fallen to $134.75.

Position: 3/6/2012

· Wrote 7 March 137 calls, bought 7 139 calls, net credit $0.35

The market rebounded to $140.85. I was assigned at 137 and exercised at 139. Entire month results:

Premium income ( 0.53 + 0.35)= 0.88 Left $2.00 of the rebound on the table.

April 2012 Cycle results:

Position: 3/19/2012

· Wrote 7 April 143 calls, bought 7 April 145 calls, net credit $0.63

The market again fell after this. I unwound the spread for $0.08 debit. Total gain on the spread $0.55. Spy had fallen to $138.22. Entire month results:

Premium income $0.55

May 2012 Cycle Results:

Position: 4/25/12

· Wrote 141-142 spread for $0.36 net credit

Market fell, unwound for $0.05 for a gain of $0.31

· Wrote 137-138 spread for $0.34 net credit.

Market continued fall, to 129.74. Options expired worthless.

Premium income (.31 + .34) =.65

June Cycle Results:

Position 5/18/2012:

· Write 131-132 spread for net credit of $0.53

Market recovered to $134.14

Premium income= (.53) left $1.00 of the gain on the table.

July Cycle Results:

Position 6/15/2012

· Write 136-138 spread for $0.85 credit.

Market rose to $136.47

Premium Income: (.85) I delivered the shares at 136, leaving $0.47 on the table. I had to repurchase shares at 137.02, leaving another $1.02 on the table for a total of $1.49.

August Cycle Results:

Position 7/27/2012

· Write 138-140 spread for $0.76 credit.

The market rose to 142.18.

Premium income: (.76) Left $2.00 on the table.

September Cycle Results:

Position 8/23/2012:

· write 142-144 spread for .77 net credit.

Market rose to $145.87

Premium income: $0.77 left $2.00 on the table

October Cycle Results:

Position 9/26/2012:

· write 145-147 spread for $0.65 credit

Market fell to 143.39, both expired worthless.

Premium income $0.65

=====================================================

9 month results:

Premium Income:

(.88) + (.55) + (.65) +(.53) +(.85) +(.76) +(.77) + (.65) =$5.64

During this period SPY appreciated from 136.47 to 143.39, a gain of $6.92, or a bit over 5%

Of this we left $7.49 on the table as prices fell and then recovered, for an overall capital loss of $0.58. Adding back our premium income, our total gain was $5.04. On the original 136.47 price this is a gain of 3.6%, or about three quarters of the SPY gain over this period.

My overall assessment is that most traders would be disappointed in this strategy. Yes, a pure covered call strategy would have left more on the table as prices fell and recovered. But while the covered spread allows the writer to participate in big price gains or big price rebounds, the more moderate price appreciation and rebounds typical of such a broad index as SPY mean that the $2.00 difference between the strikes still coughs up a lot of potential recovery. This is easily seen in August and September.

For volatile individual stocks, however, the strategy may be more effective. The larger capital gains, and price rebounds, would play to the strengths of the covered spread; whereas the income earned would be comparable since it is not sensitive to the higher volatility of the options.

Source: Covered Spreads On The SPDR S&P500 ETF: 9 Months Of Results

Additional disclosure: This article is an example of why it is useful to test a strategy before it is fully implemented to the traders dismay. Notice however, that performance under the various scenarios was as expected.