You may already be familiar with covered-call writing…but have you ever considered writing a covered call with a high-delta LEAPS call option as the underlying, instead of a stock? This post explains how this strategy works, comparing its advantages and risks to “traditional” covered calls.
One of the most popular options strategies, from beginning to advanced traders, is the covered-call play. (If you’re a TradeKing client, this strategy is Play #6 in the Options Playbook in the Education menu.)
In this strategy, you sell (or “write”) a call option on a stock you already own. The goal is to keep the premium you earn by selling the call, but if the market happens to rise and your stock is called away from you, you’re “covered” because you already own shares of the stock. Naturally, the maximum risk is that your stock position goes to zero, thus losing your investment.
But what if you switched out the stock as your underlying for a LEAPS call option with a high delta? If you’re not familiar, LEAPS stands for Long-Term Equity AnticiPation Security, a fancy name for what is essentially a long-term options contract. (You can really get up-to-speed by checking out my blog series on LEAPS.)
Delta is the most commonly known Greek, measuring the amount an option’s price will theoretically change for a corresponding one-point change in the price of the underlying. As delta gets higher on a given option, that option starts to move more in lock-step with the underlying stock it’s based upon. (While delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security, there’s no guarantee that this forecast will be correct.)
So let’s bring these two concepts together: if you have a LEAPS call option with high delta (80 or more), you’re dealing with an option that will eventually expire (unlike stock), but for the short-term it’s behaving pretty similarly to the stock it’s based on. In other words, in the short term the LEAPS call is a decent, but cheaper surrogate for the underlying stock.
Let’s use an example:
AAPL stock trading at 141 (as of 6/9/09)
Buy 1 Jan 2010 110.00 AAPL call for 38.70 -- this is your underlying stock surrogate
Sell 1 July 2009 155.00 AAPL call for 2.47
The max risk of the trade by the first expiration is the net debit paid, minus the credit received from selling the call, or 36.23 (38.70 – 2.47) equal to $3,623 in our example.
You’ll notice we bought a very in-the-money (ITM) LEAPS call for the underlying – that’s how we got the high delta. (You’ll probably have to go at least 20% ITM to get the high delta you need for this trade.) The sold call, on the other hand, is out-of-the-money.
So why take this twist? A couple of reasons:
It’s considerably less expensive to buy a LEAPS call versus stock. To buy 100 shares of AAPL stock as the underlying, you’d pay $14,100 and receive $247 for writing the covered call. If you buy the LEAPS call, however, you’d pay $3,870.00 and receive the same $247 for writing the covered call. But keep in mind that a LEAP, as any option, is a decaying asset and thus carries much greater risks than holding a stock.
The static return on the trade looks much sweeter. Assuming the underlying doesn’t move at all and you keep the full premium – a scenario referred to as “static” return, versus “if-called” return, on an option – the LEAPS trade looks a lot better than the stock trade.
Think of it this way: you get the same $247 premium either way, but the static return on a $14,100 investment is only 1.75%. On the LEAPS call, it’s 6.38%. Remember: the LEAPS call will decay over time, but the long-term option decays at a much slower rate than the near-term. (Don’t forget: assuming a one contract spread and the near-term call expires worthless, there will be total commission costs of $16.80 to enter and exit this trade: $4.95 per leg plus 65 cents per contract traded).
If you’re absolutely convinced LEAPS-based calls are great, make sure you consider the risks of this trade:
LEAPS, unlike stock, have an expiration date. That means you’ll probably want to run this trade on LEAPS fairly far into the future. In this example, the LEAPS call we chose has over 220 days until expiration.
You have to manage two different expiration dates. A “traditional” covered call usually has only one expiration date to watch, the call you sold. Check out my blog series How We Roll for more on that.
You have more to fear, should you get assigned. “Assignment” refers to the scenario in which the person who bought the call you sold decides to exercise their right to buy stock. Unlike a traditional covered call, where you wouldn’t mind being assigned on the short option, on the LEAPS version you don’t want to be assigned because you don’t actually own the stock yet. Instead, you hope to be able to sell out-of-the-money calls month after month until the LEAPS call expires.
If you do get assigned the short call, don’t make the mistake of exercising the LEAPS call. Sell the LEAPS call on the open market so you’ll capture the time premium (if there is any) along with the intrinsic value. Then buy the stock, which you will be required to deliver. This is a good time to have a broker that understands options, so call us at 877-495-5464 and we’ll help you through the process.
If the stock price exceeds the strike price of the short option before expiration, you might want to close out the entire position. If the strategy was implemented correctly, you should see a profit in such a case.
Give this baby a name – and win a FREE 2nd edition Options Playbook!
I am in the process of writing The Options Playbook’s second edition, and I plan to add this play (along with a lot of other great new content) to the book. Even though this play is fairly common, it doesn’t have a unique name of its own, so this is my call for help in naming it.
The most accurate name is a diagonal trade because we have different expirations and strikes. A fun name like iron condor is really what I am looking for. “Jumpin’ Jiminy” is a fun name we’re kicking around, a nod to the LEAPS part of the trade. I have also seen it referred to as a LEAPS covered call – accurate, but boring. But none of these really do it for me.
What would YOU call this trade?
Submit your best names for this via comments here. If we use your name in our next edition of the Playbook, we’ll send you a FREE copy! (Think of all the fame and glory you’ll get for naming your very own options play.)
Thanks – looking forward to your name-suggestions!
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
[image: Leap of Faith by ClickFlashPhotos on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
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