Covered Call Writing is fine but VERTICAL SPREADS
will cut your RISK exposure.

As we know a COVERED CALL is a strategy when someone would sell a CALL OPTION while simultaneously owning the underlying stock. The writer (seller) would enter this strategy with a neutral to mildly bullish opinion on the underlying stock. By selling a call option against the stock, one would decrease the risk of owning the stock but only to the amount collected from the sale of the call premium with no allowance for protection under the cost basis. Covered call writing has become quite common in today's trading due to its simplicity.

Many will enter a covered call situation attracted to and looking to capture a high premium locking in on how much premium can be collected - the higher the amount one can collect from the sale of the call option, the lower the cost basis. I am not looking to slam the covered call writing strategy but I would like to point out the risk exposure that is present should the underlying take a big hit and drop much lower than the entry price.

In the tables to follow I will demonstrate with a VERTICAL SPREAD, how one can stay on track with the same strategy while maintaining the neutral to bullish opinion. You will notice that the profit potential will be pretty much the same but MORE IMPORTANTLY the worse case scenario EXPOSURE will be significantly eliminated by switching to the SPREAD. Keep in mind there are several variations in achieving this type of spread but I will keep it simple to illustrate the  idea of keeping the exposure to a much more comfortable level.

Underlying Stock ABC is trading at 84.00

The June 80 Calls are selling for 4.50 and the June 85 Calls are selling for 1.55

We will base this study comparison on 1000 shares (not including commissions).

For the STOCK version – a covered call entry would have a cost basis of 82.45 and would have an out of pocket expense of $82,450. The entry for the VERTICAL SPREAD would have a cost basis of 2.95 to buy 10 contracts of the June 80 calls @ 4.50 and to sell 10 contracts of the June 85 calls @ 1.55 which would cost $2,950.

In the tables below you will see a P&L based on where ABC will be at EXPIRATION.
 

As we can see from the side by side comparison the VERTICAL SPREAD is exposed to less risk..One might say that the probability of ABC reaching extreme lows is very unlikely - but wouldn't it be nice to know your EXPOSURE was eliminated if you woke up one morning and found ABC was another ENRON?

The point here is that with a little more knowledge of OPTIONS you can still maintain your objective and put yourself in a better position by finding the BETTER DEAL. Not only did this adjustment provide a safer haven – lets not forget the rate of return should ABC close at 85 or better - The Stock version returned 2.6% or 5.2% if you bought ABC on margin - The Spread version returned 69% and as far as this OPTION STRATEGIST is concerned – the comparison between these two is a no brainer.