LEAPS and Covered Call Writing: A Review and a Hypothetical Example

11/05/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Using LEAPS as a stock surrogate with covered call writing has its advantages and disadvantages, so Alan Ellman, of TheBlueCollarInvestor.com outlines both and warns that it is up to each individual options trader to measure his own risk tolerance to make a determination as to whether this strategy has a place in his portfolio.

A covered call writing-like strategy involves buying deep in-the-money LEAPS options and then selling short-term slightly out-of-the-money call options. LEAPS become a stock surrogate. The term LEAPS stands for Long-Term Equity AnticiPation Security. They have expiration dates up to two and a half years out.

Defining Spreads

Technically, covered call writing with LEAPS is known as a diagonal spread because both options have the following characteristics:

  • Same stock
  • Different strikes
  • Different expiration dates

This differs from a calendar spread which has the following characteristics:

  • Same stock
  • Same strike
  • Different expiration dates

Hypothetical Example

  • BCI trading at $60.00 in August, 2015
  • Buy 1 x January, 2017 $40.00 LEAPS for $22.00
  • Sell 1 x September $65.00 call for 2.00

Advantages of LEAPS

  • Risking less capital ($22.00 per share as opposed to $60.00 per share)
  • Higher rate of return (ROI) as gains are magnified due to leverage

Disadvantages of LEAPS

  • Requires more active management because we don’t own stocks to deliver
  • Smaller pool of stocks to select from (fewer stocks have LEAPS compared to Monthlys)
  • Wider bid-ask spreads than stocks
  • Leverage works both ways with losses also magnified

Outcomes

Best Case Scenario

Ideally, we would like share price to rise $0.01 below the $65.00 strike and having the short call expire worthless. Here we would have generated $2.00 in option premium plus $4.99 in unrealized share appreciation. We can then write another short call.

Worst Case Scenario

Our maximum loss, if share price moves to $0.00 is $22.00 – $2.00 = $20.00 per share. This, of course, assumes no position management, an unrealistic assumption for Blue Collar Investors.

Stock Price Remains the Same

The short call expires worthless and we write the next month’s (October) slightly out-of-the-money call

Stock Price Moves Up Slightly

We can close both legs of the trade for a small gain. We may also opt to take no action in hopes of the option expiring worthless if share price remains below the strike price.

Stock Price Moves Down Slightly

We can close both legs of the trade for a small loss. We may also decide to take no action if the decline is minimal and write another call the next month.

Stock Price Moves Above the $65.00 Strike

This is where our management skills come into play. Let’s say the share price moves up from $60.00 to $68.00. As expiration of the short call approaches, the premium will be slightly above $3.00, say $3.10 ($3.00 of intrinsic value + $0.10 of time value). The $40.00 LEAPS is $28.00 in-the-money plus has a larger time value component, let’s say $1.50 for an estimated premium of $29.50. Now, if we exercise the LEAPS and sell the stock for $65.00 from short-call exercise, our net gain is $25.00. However, if we close the spread by buying back the short call for $3.10 and sell the LEAPS for $29.50, we have a net credit of $26.40, an additional profit of $140.00 per contract.

We do have one other course of action here. We can roll the option to the next month $60.00 call or roll out-and-up to a higher strike. The calculations will dictate whether this latter strategy meets our goals.

How to Structure a LEAPS/Covered Call Trade

These trades should be set up such that, if both legs are closed, it is closed at a profit:

Difference between the two strikes + premium generated from the short call must be greater than the cost of the LEAPS option.

Brokerage Concerns

We will need special approval to use this strategy, probably a higher level of approval than for traditional covered call writing. We will be asked about our goals, risk tolerance, knowledge of options trading, as well as portfolio balances and net worth. These requirements are broker specific so we must ask our broker for this information.

Self-directed IRA accounts

As a general rule of thumb, traditional covered call writing is permitted in self-directed IRAs but LEAPS covered call writing is not.

Discussion

Using LEAPS as a stock surrogate with covered call writing has its advantages and disadvantages. Each investor must measure his own risk tolerance to make a determination as to whether this strategy has a place in the family portfolio.

By Alan Ellman of TheBlueCollarInvestor.com

Related Articles on OPTIONS