The selection of the proper in-the-money call to use is a critical
element in the success of this strategy for trading stock options
In order to obtain an accurate delta of all trading stock options
under consideration for stock replacement use, you can go to
any number of web sites or consult your broker. If all else
fails, there is a little trick of the trade that can be used
to aid in selecting a call that is deep enough in-the-money
to suit the trading stock options replacement criteria.
To do this, check the quote of the corresponding put (i.e. the
December 47.5 put if you are looking at the December 47.5 call
for stock replacement). If there is no bid quoted for the put,
then the call is deep enough in the money to consider it for
a trading stock options surrogate. There are several reasons
for this being an effective strategy for trading stock options,
which we wont cover here, but for the purposes of this discussion,
it is enough to know that this method does work.
So, when trading stock options at $58.90, the December 47.5
calls met the criteria for stock replacement. This call had
a mid to high 90s delta and its corresponding put had no bid.
The December 47.5 call was trading at $11.45 or $.05 over parity.
By purchasing these trading stock options, you would be equivalently
buying the trading stock options at $58.95 (the strike price
plus the option price).
Lets say that you bought the December 47.5 call for $11.45.
If a total of 10 calls were purchased (an equivalent of 1000
shares), you would lay out a total of $11,450 to fulfill your
trading stock options requirement on this buy-write. If you
had purchased the trading stock options outright, you would
have spent $58,900. The difference between the capital needed
to purchase the trading stock options
outright ($58,900) and
the capital needed to buy the in-the-money call ($11,450) is
the key to this trade.
Now that you have your trading stock options (via the calls
you bought above), it is time to sell covered calls against
this position, which would be the December 60 calls for $1.30.
If the trading stock options stay at their present level, you
would then capture the $1.30 premium that you sold the December
60 calls for because they finished out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return
in only two weeks. This well out-performs the return garnished
on a $58,900 investment which would only be a 2.21% return in
the two weeks, if you purchased the actual trading stock options.
As we know, the maximum profit of $2.35 will be attained if
the trading stock options reach $60.00 or above. This return
comes from the $1.30 you received in the premium for the sale
of the now worthless December 60 call plus a $1.05 profit from
the December 47.5 call you purchased. With the trading stock
options now at $60.00, the December 47.5 call is worth parity,
which is $12.50.
You purchased the call for $11.45 thus you received a $1.05
capital gain in the trading stock options. This profit of $2350.00
represents a 20.5% return in two weeks verses a 3.98% return
in two weeks, if you had purchased the actual trading stock
As you can see, you are getting the same overall dollar return
on much less money - which creates a much higher percentage
rate of return. This is one of the positive leverage effects
that the proper usage of trading stock options
When you initiate this trade, you are buying and selling two
different options simultaneously which is known as a spread.
A spread is a trade which involves the buying of one option
against the sale of a different option simultaneously.
By buying the December 47.5 calls for $11.45 and then selling
the December 60 calls at $1.30, you are buying the December
47.5 December 60 call spread for $10.15. This type of spread
is known as a vertical spread.