A bull call spread can be more advantageous than a covered call strategy, particularly in terms of risk management, because it has capped downside risk, whereas a covered call strategy has significantly more downside risk. Here's 4 reasons why:
Bull Call Spread
How It Works: You buy a call option and sell another call option with a higher strike price, both on the same underlying stock and with the same expiration date.
Limited Risk: The maximum loss is capped at the net premium (cost) you paid to establish the spread. This means your downside is fully defined from the beginning, and no matter how far the stock price falls, you can't lose more than this predefined amount.
Why This Is Advantageous: You have a clear worst-case scenario, which helps in risk management, particularly in volatile markets. Even if the stock plummets, your losses are controlled.
Covered Call
How it works: You buy 100 shares of stock and sell 1 call option with a strike price above the purchase price of the stock in order to collect a credit from the premium received.
Unlimited Downside Risk: Since you own the underlying stock, if the stock price drops significantly, your potential losses are theoretically unlimited (limited only by the stock falling to zero). While the premium collected from selling the call provides a small buffer, it does not protect you from large losses if the stock price collapses.
Why This Is Riskier: The exposure to the stock means you are vulnerable to major downturns. In bearish or highly uncertain market conditions, holding the stock can result in substantial losses that far exceed the premium earned from selling the call.
Bull Call Spread
Lower Capital Requirement: Since a bull call spread involves buying and selling options, you don't need to own the underlying stock, which requires significant capital. The amount of capital tied up is just the cost of the spread (the difference between the premium paid for the lower strike call and the premium received for the higher strike call). This makes it a more capital-efficient strategy.
Why This Is Advantageous: For traders or investors with limited capital, this strategy allows them to gain exposure to potential upside in the stock without the need to purchase the stock outright, reducing the amount of capital at risk.
Covered Call
Higher Capital Requirement: A covered call requires owning the underlying stock, which means a significant amount of capital is tied up in holding the shares. This can be a less efficient use of capital, especially if the stock doesn't perform well or declines in value.
Why This Can Be Disadvantageous: If the stock price falls, not only do you face capital losses on the stock, but you’ve also committed a large amount of capital that could potentially be used more efficiently elsewhere.
Bull Call Spread
Limited Reward, Limited Risk: The upside in a bull call spread is capped by the difference between the two strike prices, but the downside is also capped. You know both your maximum profit and maximum loss upfront, making this strategy favorable for traders who want to clearly define their risk/reward parameters.
Why This Is Advantageous: The predictability of both risk and reward allows for better strategic planning, especially in situations where you expect moderate gains but want to control the amount you’re willing to risk.
Covered Call
Limited Reward, Unlimited Risk: While the premium you collect provides some income, your upside is capped by the strike price of the call option. Meanwhile, the downside risk is theoretically unlimited because of stock ownership, meaning you could face significant losses if the stock declines sharply.
Why This Is Riskier: The risk/reward profile is skewed. While the reward is capped and known, the risk is open-ended and can become disproportionately large in the event of a severe stock drop.
With a bull call spread, once the trade is placed, you don't need to monitor the position constantly because your loss is already capped by the structure of the trade. There's no risk of losing more than the initial investment in the spread, similar to how a stop-loss will automatically trigger when the price falls to the set level.
Trading Central Options Insight gives traders the ability to see Bull Call Spread strategies that have preferred probabilities of profit by answering 3 simple questions:
Here is an example of a Bull Call Spread on NVIDIA Corp (NVDA:NASDAQ) compared with a long call and a Bull Put Spread, all expiring by September 20th, 2024.
Bull Put Spreads are another way to create income instead of writing covered calls which we will touch on in an upcoming post. Stay Tuned.
In summary, a bull call spread is more advantageous than a covered call in situations where you want to limit and cap your downside risk while still gaining exposure to potential upside. By using a bull call spread, you avoid the significant capital exposure and potential for large losses inherent in stock ownership, which is a key drawback of the covered call strategy. This makes the bull call spread a more controlled and risk-managed approach, especially in uncertain or moderately bullish market conditions.
TC Options Insight was designed to show retail stock traders that have never considered trading options, the benefits of options strategies that replicate being long or short stock with less risk while learning the importance of volatility and expected price movement in the strike price selection process.
The investment ideas presented here are for information only. They do not constitute advice or a recommendation by Trading Central in respect of the investment in financial instruments. Investors should conduct further research before investing.
Gary Christie is head of North American research at Trading Central in Ottawa.
.png)
.png)
.png)
