Trading Covered Calls on LEAPS (Part 1)

11/12/2008 4:01 pm EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Covered calls are a great strategy for reducing account volatility and earning income against your long stock positions. On the Learning Markets Web site, we have also talked about using LEAPS options as a way to "lease" stocks for less money than it costs to acquire the stock outright. Is there a way to combine the benefits of these two investing strategies to get the best of both worlds? Yes, there is: By selling covered calls against a long LEAPS option position.

This series of articles discusses the covered calls on LEAPS (AKA diagonal spreads) strategy. If you have a basic background understanding of covered calls and LEAPS, this should be something you will be interested in. If you need a refresher on these subjects, please check out the links below.

In part one, we will start the discussion about covered calls on LEAPS by looking at the risk profile of that trade compared to its potential benefits. A covered call on LEAPS has distinct advantages, but understanding the risks is important as well. Here are a few of the key concepts to keep in mind when trading a covered call on a LEAPS option:

  1. You are short a call without an underlying stock position. This means that if you are "called out," you will find yourself short the stock.

  2. A LEAPS option has time value that is melting each day as you near expiration.

  3. Option trades are often at a higher commission rate, and this will increase your trading costs.

The benefits of trading a covered call on a LEAPS option are significant. I have outlined a few of those in the list below:

  1. The LEAPS contract is cheaper than the underlying stock, and that increases your leverage and potential ROI.

  2. Because the LEAPS contract is cheaper, you have less risk in absolute dollar terms than when holding the underlying stock.

  3. This is a strategy that can be used with index options, as well as stocks and ETFs.

  4. Using this strategy on index options with European-style expiration eliminates the possibility of early exercise of the short call.

Balance the risks and benefits to decide whether this strategy works for you and to help decide the best way to implement it within your portfolio. As I release this series of articles, I will use a case study to illustrate the concepts. Repeat the steps in the case study on an option of your choice in a paper trade. Repeating the method yourself will help you to understand the strategy and remember how it works.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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