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C. Raja Rajeshwari

What is the difference between the covered call (9/11/2003) and vertical spreads (bull call spread and bull put spread) - R Ganesan

The two aspects, which make the bullish strategies - covered call and vertical spreads - different, are the initial investment required and the profit-loss profile. The return on the initial investment is higher in the case of spreads as compared with covered calls. The initial investment is higher in the case of covered call as it involves a position in the cash market.

When to use: A covered call is used as an income-enhancing strategy rather than a directional trading strategy. If you are going to hold the underlying stock for a long time, then a covered call is used to earn extra income from a temporary downtrend in stock price. The loss, which arises from the decline in the stock price below the price at which you had purchased, is not of much impact as the position in the stock is taken with a long-term perspective. A covered call is used to earn more profits from a bullish view on the underlying rather than speculate. In contrast, vertical spreads are directional trades.

Covered call: In a covered call, you take a long position (buy) in the underlying stock combined with a short position (sell) position in a call. This combination would make limited profits on any uptrend in the underlying stock past the call strike price. As the stock rises past the strike price, the call would be in-the-money; so the loss from the call assignment would be set off from the profits made in the underlying stock. Hence the upside in this strategy is limited. The maximum profit is the premium received plus the difference between the price at which you purchased the stock and call strike price.

If the stock falls below the price at which you picked up the long position in the underlying stock, then there are losses. However, you are compensated to the extent of the premium received. So, the break-even point (no profit-no loss) is computed as the difference between the price at which you purchased the stock and the premium you received.

Hence higher the premium received, the lower would be your break-even point. The higher the call strike, the higher your profits. To get the maximum out of this strategy you have to choose a deep-out-of-the-money call that has a high premium, to balance out the risk undertaken. But, few such options are available in the market.

In contrast to this strategy, the availability choices for vertical spreads - bull call or bull put spread - are immense.

Bull-call spread: This combination is initiated by a long position (buy) in a call of lower strike price and a short position (sell) in another call with a higher strike price. The long position would cost more than the short position; hence this would be a debit spread. But the outlay to purchase the call with the lower strike price is reduced, due to the premium received from the short position.

For instance, you initiate the bull call spread in Tata Motors (Rs 420) by taking a long position in 410 call (in-the-money) at Rs 18.75 and short position in the 430 call (out-of-the-money) at Rs 8.25. The net outflow would be Rs 10.5 (Rs 18.75 - Rs 8.25).

The break-even point for this combination would be at Rs 420.5, which is the sum of the lower strike price and the premium paid for setting up the spread (410+10.5). At 420.5, the 410 call is in-the-money by Rs 10.5 which is set-off by the Rs 10.5 which you have paid.

Limited profit-limited loss: Any rise above the break-even point gives you a profit.

For instance, if the stock price rises to Rs 425, then the short position remains out-of-the-money, but the long position is in-the-money by Rs 15. Your net profit would be Rs 4.5 (15 - 10.5). Any uptrend in the stock above the higher strike price would limit profits as the higher strike price would become in-the-money and the call would be exercised.

For instance, if the stock rises to Rs 440, then the call turns in-the-money.

# Since you hold a short position in the 430 call the chance of you being assigned are high.

# In case you are assigned, then you pay the difference between the spot and the strike -Rs 10.

# You in turn exercise your long position and receive Rs 30 (440-410).

# The net profit from the spread is the Rs 9.5 (30-10-10.5). At any point, above the higher strike price, the profit is limited to the difference between the strike prices and the premium paid for setting up the spread.

Any decline in the stock below the lower strike price, leave you with both the calls out-of-the-money. The loss is limited to the premium paid to set up the spread - Rs 10.5.

Covered call Vs Bull-call spread: If you have initiated a covered call in Tata Motors with a long position in the underlying at Rs 420 and a short position in the out-of-the-money 430 call, you would receive Rs.8.25. In case the stock rises to Rs 440, you would pay Rs 10 on assignment of the 430 call. You would also make a profit of Rs 20 on the long position. The net profit is Rs.18.25 (20-10 + 8.25).

Unlike covered calls, a bull-call spread provides you with leverage. So your profits are also enhanced and the losses are also magnified. For instance, with an initial outflow of Rs 10.5, the maximum profits you receive is Rs 9.5. However, you can also lose the entire sum invested. The same is the case with a bull-put spread.

Bull-Put spread: A bull-put spread is also initiated in the same manner - a long position (buy) in a put of lower strike price and short position (short) in another put with a higher strike price. Unlike the bull call spread, this would be a credit spread, as you receive premium on writing the put of higher strike price.

The break-even point for this combination would be at the higher strike price less the premium received. For instance, if you initiate a bull put spread when the underlying spot is at Rs 420 by a long position in a 410 put (Rs 6) and a short position in a 430 put (Rs 22), the net premium you receive is Rs 16 (22-6). The break-even point is Rs 414 (430-16). At Rs.414, the put you have written is in-the-money, which means that on assignment you have to pay Rs 16 - the difference between the strike price and the spot. However, this is set off by the premium you have received. Any decline below the lower strike - Rs 410-would limit your losses to the difference between the strike prices and the premium received, which is Rs 36 (430-410 +16).

The maximum profit from this strategy is the profits you receive. Any rise in stock price above Rs 430, would mean that both the puts are out-of-the-money and they expire worthless.

When to use: Vertical spread are used for directional trades. If you are the view that the underlying would have significant rise, then you are better off buying a call as the bull call or the bull put spread would limit the upside. Hence the above-mentioned spreads are used when the underlying would make narrow or range-bound uptrend. A Bull-call spread is used when you money to set up the spread and meet margins too. On the other hand, the bull-put spread can be initiated at no cost at all.

Note: In a bull call spread, the order can be set up as a spread, which would reduce the margins maintained, but until it finds an exact match, the order would not be executed. The spread can also be set up in two different transactions, but margins required would be higher.

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