Index Call Option Spreads for Income
Posted by sellacalloption
Index Call Spreads
This strategy can be used to enhance returns on a stock portfolio. The first step is to look at the portfolio and determine which index it correlates most closely to. A mostly technology stock portfolio may correlate most closely to the NASDAQ, or the QQQQ ETF. A portfolio of foreign stock might have the closest correlation the EAFE or the EFA ETF. For our example we’ll assume that the investor has a $260,000 portfolio that is highly correlated to the S&P 500. The ETF for the S&P 500 is the SPY. The next step is to determine how many option contracts represent the value of the portfolio. As of the writing of this book the SPY is trading at about $130 so 20 contracts ((20 X100) X $130) = $260,000. The next step is the sell a credit spread on the SPY. If we sell the 133 X 134 spread we receive a credit of 0.25 cents or $500. The maximum risk on the spread is the amount of the spread minus the credit or 0.75 cents or $1,500. If the SPY stays below 133 we keep all of the credit. If the S&P declines, the portfolio will decline and we’ll still keep the credit for additional income or an offset to the decline. If the SPY rises above 134 at expiration we’ll have our maximum loss on the spread, but it will be offset by the gain in the portfolio. Say the SPY is at 135 at option expiration. We’ll have a loss of $1,500 in the call spread, but if the portfolio is 95% correlated to the S&P 500, we’ll have a gain of 3.85% on the SPY. Assuming the portfolio has a 95% correlation to the S&P 500 that translates to a gain of over $9,500 in the portfolio. Using this strategy consistently the investor will have profits on the spread when the market is flat, declines or rises slightly. When the market makes a large gain, the investor will have a loss on the spread that is offset by the gain in the portfolio. Strike prices for the spread can be selected using out of the money options that have a low probability of loss. Remember when a loss does occur it is offset. Over time there should be more winning months than losing months based on lognormal distribution of market returns and the strategy will have a positive expected return.