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Jun 3, 2016

From Theory To Practice: Juicy Covered Calls

By:Sage Anderson

Juicy isn't just a brand of overpriced sweatpants. More importantly, it's the nickname Dr. Jim Schultz assigns to a ratio call spread he presents and dissects on a recent episode of From Theory to Practice.

Most tastytraders are likely well aware of the covered call - an options trading strategy that involves long stock in conjunction with a short call. This strategy limits upside gains, but also helps reduce cost basis in the long stock position.

Detailed information on covered calls is available through this link.

On his show, Dr. Schultz introduces the concept of a "juicy" covered call, which effectively equates to a long stock position plus a ratio call spread. A ratio call spread is different than a traditional vertical call spread. Instead of simply buying a call and selling a call (1:1) to create the vertical spread, we buy a call and sell two calls against it to create the ratio spread. We typically do this in a ratio of 1:2. Two short calls for each long call in the spread.

The nature of this position becomes a lot more clear when one compares and contrasts the strategy with a long stock position and a traditional covered call position, as Dr. Schultz does very clearly on the show.

As indicated on From Theory to Practice, a long stock position is a purely directional trade. If the stock goes up, the trade makes money - if the stock goes down, the trade loses money. Pretty simple.

A traditional covered call is slightly less directional. It’s still bullish, but if the stock goes down, there’s a little bit of a buffer (as compared to long stock only) because the credit from the short call helps to offset some of the losses from the decline in the stock price. If the stock price increases, gains from the long stock position will eventually be offset by the short call position (thus capping some of the upside potential of the position as compared to long stock only). The added benefit of the covered call compared to the long stock position is that if the the stock trades sideways and doesn’t move much in either direction, the trader benefits from the decay in the premium of the short call.

A “juicy” covered call, as structured and presented by Dr. Schultz, acts more like long stock in terms of potential for loss on the downside. However, it also allows for increased potential profit on the upside as the stock price appreciates.

The slide below illustrates the varying risk-reward characteristics of the three positions using hypothetical SPY data:

As you can see from the example above, if the SPY were to drop to 203, the "juicy" covered call loses almost as much as the long stock position. However, if the SPY rises to 215, then the juicy covered call produces a higher level of profit than the traditional covered call.

Making the decision to deploy one of the above strategies will depend on your specific outlook and risk profile. It's possible none of them fit in your portfolio given current market conditions.

The most important takeaway from Dr. Schultz's discussion is that we've added to our arsenal of potential trading strategies. And for that, we thank him.

If you have any questions about today’s topic, please don’t hesitate to reach out to Dr. Schultz directly at support@tastytrade.com.

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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