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How to Increase Profits with Covered Calls on LEAPS
07/10/2009 12:01 am EST
Covered calls are a great strategy for reducing account volatility and earning income against your long stock positions. On the LearningMarkets.com 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 in order to get the best of both worlds? Yes there is, by selling covered calls against a long LEAPS option position, also known as diagonal spreads.
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.
- 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.
- A LEAPS option has time value that is melting each day as you near expiration.
- 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, however, are also very significant. I have outlined a few of those in the list below.
- The LEAPS contract is cheaper than the underlying stock, and that increases your leverage and potential profits.
- Because the LEAPS contract is cheaper, you have less risk in absolute dollar terms than holding the underlying stock.
- This is a strategy that can be used with index options as well as stocks and ETFs.
- Using it on index options with European-style expiration eliminates the slight possibility of early exercise.
Balance the risks and benefits to decide whether this strategy works for you and to help you decide the best way to implement it within your portfolio. As we release this series of articles, I will use a case study to illustrate the concepts. On your own, 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.
Watch the video below:
By John Jagerson of LearningMarkets.com.
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