Variations of Covered Calls | Strategies for IRA
May 5, 2016
Lower cost basis. Extend duration. I have that tattooed on my chest (written backwards so I can read it in a mirror). Covered call writes, which consist of buying stock then selling a call against the stock, are a strategy used to lower cost basis. However, capital requirements to buy just 100 shares of stock can be substantial depending on account size. Fortunately, there are covered call variations that can be used.
One of the biggest drawbacks to covered call writes is the capital requirement. For example, buying 100 shares of SPY in a non-margin account requires nearly $21,000 in buying power. Selling the 30 delta call in May will reduce that by around $105, but the buying power required remains substantial. But we don’t necessarily have to own stock in order to implement a covered call strategy.
One way we can reduce cost basis before ever even owning stock is selling a put. In a non-margin account, selling a put will not reduce capital required by much; however, in a margin account, capital requirements diminish substantially. What really makes selling a put attractive, aside from any potential reduction in capital requirements, is the increased probability of being profitable. Selling an out of the money put generates premium. If the stock is trading about our short strike price come expiration, our short put expires worthless. Should the stock fall below our short strike, we will be put stock but our cost basis has already been reduced.
Another way to replicate selling a covered call is through a diagonal. This involves purchasing a long-dated call then selling a shorter-term out of the money call. Go back to the SPY example. Purchasing the 60 delta January 202 call expiring in January 2017 will cost a little under $1500. Selling the 30 delta June 213 call expiring in 2016 will reduce cost basis by around $180. If the June call expires worthless we can repeat the process for July.
One more way to reduce cost basis is using a covered strangle. Here, a covered call is sold against long stock just as in a regular covered call. Then, an additional short put is sold as well. This strategy generates additional premium; however, it also uses a bit more buying power.
Depending on account size and margin availability, different strategies may be appropriate for different accounts. We like to focus on delta, vega and theta exposure when using covered calls or a variant. The goal, regardless of the strategy, is reducing cost basis. By lowering cost basis, we are simply increasing our probabilities of being profitable.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Strategies for IRA | Variations of Covered Call: April 19, 2016
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