There is a reason I almost exclusively write put spreads and not cover spreads, and I would argue it’s a very good reason.
First off, what are spreads. For those who do not know, spreads are when you buy an option and sell an option on the same security. For instances you buy a $145 call and sell the $147 call, this is commonly referred to as a 145/147 call spread. If the stock finishes at $150, the $145 option you own is worth $5 and the $147 option you sold is worth -$3. This of course would net you $2.00, and as long as it was a half way decent trade, you paid considerably less for this call spread than $2.00. Put spreads are the exact same but are for puts, meaning if you had a 147/145 put spread and the stock finished at $140, you would have the same result of $2.00 (+7.00, -$5.00).
But it is time to step back for a minute and think about what an individual call or put actually does. It buys you or sells someone the right to execute at a price, for whatever their reasoning. There lies the potential pitfall, dividend capture.
When I first started trading spreads, I thought to myself “what happens is someone executes the option, for whatever reason.” So I contacted my broker and asked them hypothetical questions.
“What happens if someone executes a call in a spread I have to capture a dividend?” -Me
“That rarely happens.” – My broker
“Could it happen?” -Me
“Well yes, but you wouldn’t find out until the next day, because we find out they execute at the close of a day and update the next morning” – My broker
“So if I had a single contract on a $90/$100 call spread that was executed, my account would receive $10,000 and my call remaining would be subject to the market the next day or until I could trade it?” -Me
“Yes.” – My broker
“So if I have a call spread, they execute out, and I am left with my end that opens -20% on the stock, I potentially could have a margin call (lose my money plus some)?
“Very unlikely to happen” – My broker
“Could it happen?” -Me
“Yes, but again that would very very rare” – My broker
That’s all it took for me to be terrified of call spreads, especially if they are on dividend paying stocks. When someone strikes out the part you sold, your remaining position gets real, like.. kite in the wind real. Now he can tell me its 1 in 1,000,000, but that’s still too high for me to risk my account. That 90/100 example call spread, might of had a net investment of $500, and if you get struck out and the security tanks -20%, you stand to lose $2,000 (more than your initial investment). I don’t like that, I want my options to have a limited loss (more conservative).
With put spreads, it makes no sense to strike out, because there is no dividend to capture. They are selling you a stock if they strike (not going to have any ability to capture dividends). If some option newbie did strike it however, you would actually show an instant gain, because they forfeited the inherit value to you. If a stock is trading at $95 and they own the $100 put, as long as there is any time left on that option (even a day or two), the option costs more than $5.00. So your account might show something like this:
Your Put: +$1,050
Their Put: $-5,50
Value at expiration, if constant: $500
Now imagine they strike the put option:
You put: $1,050
You gave up: $-500 ($100-$95 a share)
Value at expiration if constant: $550
Note: You would have 100 shares of the company in your portfolio.
The bottom-line is that no one in the right mind would strike that put, they would SELL IT for more, but if they do, they give up that inherit value to you (although you do become a kite in the wind still).
Although I’m assured it’s very rare, dividend capture is a risk for call spread traders, a risk that I simply do not want to take.