Trading Covered Calls on LEAPS (Part 2)

11/13/2008 9:26 am EST


John Jagerson

Co-Founder and Contributor,

In the second section of our series on selling covered calls against LEAPS, or diagonal spreads, I will begin walking through the entry process with a case study. The numbers and real life scenario should help you understand how these trades work and why they are attractive, but if you really want to remember the information, you should paper trade it a few times yourself. Going through the process by hand will help you retain the information, and you may come up with some questions you want to ask in the options trading forums.

In the case study, I will use an index option with European style expiration. This solves the problem of early exercise that I mentioned in the first part of this series because European style options can only be exercised at expiration and not before. The index option I will use is the Mini SPX Index Option (XPS). The XPS, or mini version of the SPX, is good for smaller traders, as the options are only one-tenth the price of the normal SPX options.

First, we need to buy the long-term option at least a year out before expiration. In this case, that means buying the December 2009 calls. The long-term options you buy can be very far in the money if you wish, but I typically suggest buying one strike price in the money. With a current XSP price of $93, that means I would buy the $90 strike price calls for $1,615 per contract.

In my experience, buying a far in the money, long-term call does not materially impact returns compared to a call that is very near to the at the money strike price. What is important, however, is that in the next step you sell a short-term call with a strike price above, or further out of the money, than the call you bought. In this case, that means I would sell the December 2008 $95 strike price calls for $535 per contract. The rate of return just based on those prices is more than 30%. Of course, risk and time value will eat away at that best-case scenario.

At this point, the trade looks very similar to a covered call. The long-term option takes the place of the long stock and protects against the unlimited losses that may occur with a short option alone. In the next section of this series, I will cover what happens if you are "called out" of a trade like this at expiration.

By John Jagerson, of and

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