July 7, 2004

Legging in to Covered Call Trades:
Buying Strength - a Technique to Propel Your Returns
by John Brasher, CallWriter Publisher

I've spoken and written a great deal about various trade management techniques designed to pull a larger return from open trades. There is, however, a technique to increase the covered call return that actually is deployed at trade entry, not after the trade is put on. Referred to as "legging in," this technique can significantly boost returns.

For those not particularly enamored of covered calls, the main objection to them is the notion that the call writer gives up all the price appreciation in the stock after the call is written. (That notion isn't necessarily true, by the way, but it is the main objection.) Like everything else, though, it depends on how one trades. With modern order entry being as flexible and powerful as it is, I'd venture to say that most covered call writes are run as buy-writes, in which the calls are written when the underlying stock is bought; usually simultaneously. But there is a different technique used by savvy call writers that can propel the covered call to a much higher return:

Buy the stock on strength;
Sell the covered call on the stock's advance.

Known as “legging in,” this covered call technique involves first buying the stock when it is showing strength by advancing on news, then selling the call only later - usually days later - as the stock price continues to rise, in order to get far more call premium (and a commensurately larger return) than by running the trade as a buy-write. It is called "legging in" because the stock and call legs of the trade are done separately. If the stock moves up significantly before you sell the call, it is possible to get significantly more for the call than if you wrote it with the stock buy - - sometimes double or triple the buy-write return.

Example: Stocks frequently move up on earnings anticipation, even though they mostly will give up the advance after earnings are reported. One earnings-driven technique is to wait for the stock to run up on earnings anticipation (which usually occurs after the earnings preannouncement is made and before the actual report), then sell ITM calls about 3 days before the announcement date.

The simple illustration below compares the differences in running the trade as a buy-write and selling the call only after the stock has moved. Let's assume that we buy hypothetical BUM Corporation (BUMM) at $21after it has started a move up on news and examine how we might do by legging in a week later when the stock is $23, as compared to doing a buy-write in which we write the call at the same time we buy the stock at $21:

Notice that legging in once the stock had moved up gave us nearly three times the return, and lowered the breakeven point by almost $2.00, compared to doing a buy-write. And this is true even though we got only 0.60 of time value on the leg-in compared to 0.90 of time value with the buy-write. The reason is that once you sell an at-the-money (ATM) or in-the-money (ITM) call on a buy-write trade, your return is fixed, whether called out or not. But by waiting as the stock moves up and legging in, you get a far larger premium for selling the same strike.

Why did I use an ITM call in the example? Because that's how I like to do it. It depends on your strategy, of course, and your read of the stock. Another trader expecting a meteoric rise might write OTM instead of ITM, and one wouldn't necessarily be wrong in doing so. But the ITM call still gives you a huge return and great downside protection. And what goes up can just as easily come down, especially if a resistance level is in the way. Use common sense. Let the stock's chart and its trading history tell you what to do.

If the stock does pull back once you've written the calls (won't you be glad you wrote ITM then?), then you use the usual bag of tricks to manage the trade, as necessary. The really great thing about legging in and writing ITM is that it positions you beautifully to close the trade at a fat profit, because the ITM call will drop dollar-for-dollar with the underlying stock (an ATM or OTM call will not). Or roll the calls down if necessary, based on where a good support level and your breakeven are. In the above example, legging in lowered the breakeven from 19.10 to 17.35, almost $6.00 below the $23 stock price when the call was written. That's a lot of protection.

AH, BUT IS THE STOCK GOING UP?

This is the crux of the legging in technique, isn't it? You have to believe, and reasonably believe, that the stock is imminently going to advance. Due to the possibility that the stock will pull back before you've written a call (and thus have no downside protection yet), you need a well-founded belief that the stock is going up. Here are some of the more popular bases for expecting an advance:

In regard to timing, my philosophy is to get confirmation - evidence the move has started. Don't rush to buy the stock before it has shown some movement. You will do better with this technique to get confirmation of the stock's direction rather than trying to get in before the move has started!

For CallWriter members, one way to spot such stocks is to look at the stock's MADI (the Moving Average Directional Indicator) when scanning our Real Time Lists™ of the highest-returning covered call trades.  The MADI shows the stock's 14-day and 50-day moving averages expressed as percentages. When the stock is showing the 50-day MADI essentially flat (00 or 01) but the 14-day MADI is higher, it can indicate that the stock has fallen back to the 50-day moving average and is advancing again.

OTHER CONCERNS

What if the stock doesn't go up as planned? If you use this technique, it will happen sooner or later. Not every stock you try it on will in fact go up. Legging in means that you get no income and no downside protection when making the stock buy. That is the trade-off for positioning yourself to make a much bigger hit on the stock move. If the stock doesn't start the expected move within a few days or stalls or pulls back, this is a bad sign. How long you should give it to move really depends on the reason for it and how long you expect it to take. If the move should happen immediately, that is your baseline. If the move might not happen for a couple of weeks, why did you buy the stock already?

If the stock does not make its move or stalls, either sell the stock to close, or simply write the calls and pick up some income for your trouble - and downside protection. Before the calls are written, be sure to set a reasonable stop on the stock that is GTC (good 'til canceled), so that you don't get caught on an adverse movement. And use a trailing stop, meaning that you move the stop up as the stock moves up. Where to set the stop will depend on how the stock trades. Day traders will typically set the stop below the prior day's close or in similar fashion, but that is too tight for the legging-in technique. Set the stop either right below the 50-day moving average (the stock should be above the 50-day MA), or set it at some percentage below the buy price, based on how much the stock typically oscillates. If the stock oscillates 10% in a week, a stop set 5% below the buy is almost guaranteed to get you stopped out for a loss.

Caution: legging in is not an excuse to write calls on a stock that you would avoid absent expectation of an immediate price rise! All the rules of sensible covered call writing still apply when legging in.

Traders worry about writing naked calls (selling calls where you don't own the underlying stock), but this is not a concern when using the legging-in tactic. You are never naked when legging in. When you finally write the calls, you already own the stock. In fact, it is the stock that is "naked" until you write the call.

THE OUT-OF-THE-MONEY ALTERNATIVE

For those feel reasonable confident in their ability to at least occasionally spot stocks advancing, but who are not comfortable legging in, there is an alternative trade: simply write out-of-the-money (OTM) calls along with the stock buy. Suppose the stock is $20 and you expect an immediate advance: simply write the 22.50 or 25 Call. If you are called out at the higher strike, you will realize a huge return, just like the trader who bought the stock at $20 and legged in.

I normally am a fan of writing the current month's call, or at a maximum writing with expiration no more than 30 days out. However, depending on when you expect the movement, that may not be practical. You might have to write the next month's calls, or go over the 30-day mark. You have to give the trade time to work. Let's compare an OTM buy-write on the BUMM trade above to legging in to it:

Legging in will usually produce a bigger return than an OTM buy-write using the same stock buy price, but it all depends on when the trade is entered, the volatility skew of the calls, where the stock is in relation to available call strikes, and other factors. In this illustration the OTM call did less well than the leg-in trade, but that will not invariably be the case. Both the OTM write and the legging-in technique depend on stock movement for maximum profitability.

The OTM premium may be small, at least compared to premium for an available call that is at or near the money, and it certainly will not provide as much downside protection, but it does provide some return and some downside protection. If instead of legging in, you chose to write the OTM call, you can always buy the calls back and close the trade if the stock retreats. Keep in mind, though, that OTM calls don't lose value dollar-for-dollar like ITM calls when the stock drops. This means that the OTM call written on the stock can hold a frustrating amount of time value if the stock pulls back, so the downside protection provided by the OTM call will be mostly illusory in some cases - not all.

Legging in is not a magical strategy - there aren't any. But for traders able to assess stock movements, and it gets easier the longer you trade, it can really knock covered call returns out of the park.

Good luck and good trading!