Frequently Asked Questions About Options: Part 6

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...continued from Part 5

What Are The Advantages/Disadvantages Of "Vertical Spreads"?

Advantages:
One advantage is knowing what the risks and rewards are for that position. The vertical spread consists of buying one option and selling another with a different strike but both expiring in the same month.

Another advantage of a vertical spread versus a single option position is that it is possible to put a cap on the amount of risk the option writer (seller) assumes, and decrease the costs of the purchase if you are an option buyer.

Disadvantages:
One obvious disadvantage is that while limiting risk, the investor also sets a limit on their profit. So, the investor would put a cap on profit potential. Also, the investor should be aware that commissions and interest charges can effect the profitability of all spread strategies.

It is suggested that the investor consult a tax advisor concerning the tax consequences of any spread strategy. Further, there are occasions where certain types of corporate actions may impact the profit/loss profile of a spread. Extraordinary dividends, tender offers and even mergers can alter the dynamics of a spread.



What Is The Risk In Selling An Out-Of-The-Money Covered Call?
Whenever you write a covered call, you first have to decide that you would be happy to lose the stock at the net effective sale price (NESP= call strike price plus call premium). If NESP does not provide you with the profit you anticipated when you first acquired the stock, you probably should not write the call.

Keep in mind that writing a deep out-of-the-money call (or, as you stated, "aÖcall at a strike price considerably higher than the stock price") may offer very little premium. You will want to ask yourself if the net premium, after the transaction costs, is enough to justify the transaction.

There is a rule of thumb often employed by many covered call writers: the potential return, if the stock is called, should be about twice the risk-free (Treasury bill) rate. As an example, if a 60-day Treasury yields 5% per annum, a two-month covered call write should produce an annualized 10% return.

A corollary is that the return engendered by the covered write should at least equal the risk-rate if the stock remains static. Another guideline regarding premium is that the downside protection gained by call writing should at least equal 3% of the stock's current market price.

continued in Part 7...

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