How to Implement Covered Call Ratio Spreads

A covered call option is sold by the stockholder to increase current income as well as partially hedge against adverse downward price movement. As long as the stock is below the strike price at expiration, the call will expire worthless.

Notice that the expiration date terminates the life of the option. A call option at expiration will be worth the positive difference--if any--between the stock and stroke price. A stock trading above/below a strike price renders put/call for that strike price worthless.

This fact points up the most important attribute about any option--its value declines with the passage of time. Options are a wasting asset. Their value prior to expiration includes a number of factors, one of which is its time value.

Option sellers are always gaining time value because the options they sold have an expiration date. The time-value of those options are declining--and the rate of that decline increases as expiration approaches. Read on to learn more.

Difficulty: Challenging

Instructions

Things You'll Need:

• A call option represents the right--but not the obligation--to buy 100 shares of an underlying asset at a specified price, called the “strike price," on or before a certain date.

1. The risk to the covered call writer is that the stock will rise above the covered call’s strike price at expiration, forcing the call seller to buy back the call--possibly at a loss--or sell the stock on which the call was written at the corresponding strike price.

2. One way to hedge that possibility is to reinvest part of the proceeds in vertical “debit” spreads, written at or above the covered call strike so that if the stock advances, the profit on the spreads will expand to their maximum.

3. EXAMPLE: Covered Call written at 60, with stock at 54. Reinvest one-half of the covered call premium in debit spreads. Covered Call Premium = 4
   55-60 Debit spread = $2.25 (6.25-4) Net position: long 1 call @ 55, short 2 call @ 60.

Tips & Warnings

• If a call needs to be repurchased due to the stock’s advance, the 65 call is adequate because it completes the butterfly, which neutralizes the short and protects the stock from being called.