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February 5, 2004
Covering Calls with LEAPS?
By John Brasher, CallWriter Publisher
| One of
the questions we get sometimes is whether it is possible to
write covered calls without buying the stock. Of course it
is. You can cover a short call by purchasing another call
option. If you buy a higher strike call, you're betting the
stock price holds or falls. If you buy a lower strike option,
you're betting the stock price goes up. This combination of
a short and long call is known as a call spread.
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The CallWriter
approach is based upon buying stocks
and writing covered calls on them, of course. CallWriter
offers the Real Time Lists™,
which are our proprietary lists of the highest-returning covered
calls, and the high returns they feature are generated by the potential
volatility of the underlying stock. That is, when the market expects
imminent movement in a stock, the options command higher prices.
There are exceptions (for example, USG was on our lists for months
due to concerns about settlement of its asbestos litigation), "imminent"
usually means one day to six weeks. Our covered call lists change
during the day and change significantly over a week; they change
even more over the course of a month. This is because the implied
volatility of the stocks themselves will change over time.
Our strategy is to write covered calls on good
stocks, and pocket the premium for consistent 3% to 5% monthly returns.
But - our Real Time Lists™ also can be used
for call spreads, which essentially are another type of covered
call. We like covered calls because they provide real downside protection.
While they will rarely provide the kind of returns that call spreads
do, they don't offer as much risk as call spreads can.
It also is possible to cover short call options
by buying a long term LEAPS call. For example, consider creating
a LEAPS position on hypothetical stock BUMM, trading at $33. You
buy the LEAPS 40C, which has 9 months left until expiration. You
could then sell the BUMM 35 call for every single one of the 9 months
remaining on the LEAPS call, and the sale of the 35C would be covered
by owning the BUMM LEAPS 40 call. The 35C and LEAPS 40C actually
creates a diagonal $5.00 calendar spread (bear call spread). In
other words, you would be short the 35C and long the LEAPS 40C.
This strategy essentially bets that the stock price at expiration
of the short call each month will not be above the 35C's strike
price.
Example: Let’s suppose
you got $1.75 for the 35 call and paid $5.50 for the LEAPS 40
call with 9 months left until expiration. If you could get $1.75/month
for selling the 35C, you would pull in $15.75 in total premium
(1.75 x 9), but have paid only $5.50 for the LEAPS. Nice profit!
Remember that this trade creates a $5.00 spread, though. If you
paid a little more, say $9.00, for the LEAPS 40C, you would make
less profit but eliminate the $5.00 spread risk.
Could this calendar spread setup lose?
It could, of course. Here are the possibilities, based on the stock’s
price and volatility over the life of the LEAPS call purchased:
1. Stock stays around $35. You
just keep selling the 35C every month against the LEAPS. The premium
will be leaner or fatter, depending on the market’s view of
the stock’s volatility.
2. Stock goes to $40. You sell
the 40C instead against the LEAPS. (You wouldn’t sell the
35C, because it is in the money, and you will be called out of the
35 for sure, which would take back some or all of the $5.00+ premium,
so you’re better off just selling the 40)
NOTE: If in a particular month you sold the 35C
against the LEAPS 40C and the stock goes to $40 or higher at expiration,
you could realize a loss. Since the total spread is $5.00 and
$1.75 in premium was received for the 35C, a net spread of $3.25
was created, which is the maximum amount you could lose on that
month's spread.
3. Stock rises sharply above $40.
Keep selling calls at or close to the money, which is where the
best premium is. Selling a call each month with a strike above $40
changes the strategy and creates a bull call spread. For example,
when the stock is at $48 you sell the 50C against the the LEAPS
40C. If the stock closes over $50 at expiration, you will be called
out of the 50C and receive $50 for the stock, but the LEAPS 40C
gives you the right to buy it at $40, pocketing a $10 profit, PLUS
the premium you got for selling the 50C. (Or just sell the LEAPS,
which will go up in value as it gets further in the money.)
4. Stock price drops. The risk
in long options is that the stock price’s movement puts the
option further and further out of the money, making it less and
less valuable.
5. Stock volatility drops. High
option premium implies volatility in the underlying stock. And no
stock maintains a continually high level of volatility. Here’s
the rub: as the stock’s anticipated volatility falls over
time – and it will - you might not get anything close to $1.75
for selling the 35C every month.
Before buying an out-of-the-money LEAPS call, you
should be bullish on the stock, because a decline in the underlying
stock will decrease the LEAPS’ value, and make it almost worthless
if the stock drops enough. If you’re buying a LEAPS put, you
should be bearish on the underlying stock. Buying the LEAPS usually
will be far cheaper than buying the stock, and options provide relatively
cheap leverage over the underlying shares. But remember that the
stock doesn’t expire.
To work the above strategy (diagonal calendar spreads)
profitably, you have to be able to correctly discern a stock’s
direction over the period until expiration of the long call. Obviously,
the strategy works better in an uptrending market, just as put spreads
would work better in a declining market. This is a poor strategy
for a channeling stock or in a channeling market.
You also don’t have to buy a LEAPS call:
you can buy an ordinary call option several months out. The call
spread strategy only works if the distant option is cheap relative
to the near option. If for example you create a 6-month time spread
(sell the current 40C, buy a 40C six months out) and the price of
the distant option is 6 times the price of the current option, there
is no way to profit. But if the distant option is 2.5 or 3 times
the current option’s cost, then a profit potential exists,
because you can sell the current option 6 times during the life
of the distant option.
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