LEAPS Covered Calls Option Strategy
Leaps Covered Calls are about purchasing a LEAP option as the long position instead of buying the underlying shares themselves. It is a very appealing alternative to the traditional covered call because the options cost much less than the shares themselves.
LEAP options are generally option contracts whose expiration date is at least one year away. This makes it a long term investment and therefore less likely to hurt you financially in the short term. But there are a few tricks you need to be aware of before taking the plunge.
LEAPS Covered Calls – Making them Count
Firstly, if you are considering a LEAPS covered calls strategy, the best options to buy for your long position are deep-in-the-money options. The reason for this, is that you want to purchase options whose pricing component is mostly intrinsic value rather than ‘time value’. Time value, or ‘theta’ if you think in terms of ‘the option Greeks’ is the factor that works against you with the passing of time. Although it is at a much slower rate for long dated options, you want to minimise it as much as possible. You need to focus on reducing the risk that your long options position will go out-of-the-money.
A general rule of thumb for leaps covered calls strategies would be to purchase your LEAPS options at a strike price that is AT LEAST 10 percent in-the-money. This means that the underlying share price can take a 10 percent price dive before your position goes out-of-the-money. So if the underlying share price at time of purchase is say $30 then you would look at LEAPS option contracts that are at least $3 in the money – preferably more. The further in-the-money you go, the higher the price will be, but you will also get more intrinsic value due to a greater delta (another option Greek). But your overall option cost will probably be only about 20 percent of what you would’ve paid if you had purchased the shares themselves. This will free up more capital for other Leaps Covered Calls positions and therefore more potential profit.
Once you have your LEAPS options in place, the next thing you do is sell (write) near month call options at a strike price at or next below the current market price of the stock. Once this is done, taking our $30 example above, three possible outcomes await you:
1. The stock will be below $30 at near month expiry date. The sold options will expire worthless so you keep the premium and sell the next month options for more premium.
2. The share price is slightly above $30. We then buy back the sold calls, possibly for less than we received and immediately sell more call options at a higher strike price for the next month out, taking a profit.
3. The share price has made a strong move upward so that the short calls are now say $5 in-the-money. We will then be exposed by $5 per share, meaning that we will be forced to sell the shares at $30 when the market price is $35. But at the same time, we hold our deep-in-the-money LEAPS call options which cover our short position and are now much more valuable. In this instance we close out both positions, making an excellent profit on the long LEAPS calls while losing $5 on the sold $30 options, less the premium we originally took. Overall, we make a profit.
Our LEAPS covered calls strategy will only be threatened if the underlying stock takes a huge price dive and falls below our long dated strike price. So if you’re a more conservative trader and this possibility troubles you, you may choose to sell in-the-money call options instead of at-the-money for your short dated positions. You will receive less profit because they will provide less time decay advantage, but should the price fall dramatically, the larger short premium received will help absorb the effect.
Another alternative would be to protect your deep IN-the-money LEAPS call options with an equal number of way-out-of-the-money put options at the same strike price as your calls. Because they are way OTM they should be very cheap, particularly if they are near month options. It will reduce your overall profit slightly but will give you peace of mind if disaster strikes.
Since these way OTM puts are really cheap, you may even consider buying more of them than your LEAPS call options, giving you even more protection.
Leaps covered calls are a great, low risk cheaper alternative to the traditional covered call. In other circles, this combination of long dated bought calls and short dated sold calls has another name – the Calendar Spread.