LEAPS And Covered Call Writing

Covered call writing entails buying a stock and then selling an option.  But what if I buy a call option instead of the stock and then sell a call option on that option? I’ll be spending less money than the outright purchase of the equity and still generate cash from the sale of the call option! This idea has come to many of you and as a result of your inquiries, this article had to be written. Although not a true covered call write, purchasing a long-term option (more than one year out), called  LEAPS, and then selling call options against that position, is an alternate strategy similar to CC writing. Technically, these trades are known as calendar spreads so perhaps we should start off with some definitions:  LEAPS– Long-Term Equity Anticipation Securities. These are option contracts with expiration dates longer than one year. Not all stocks and ETFs have these type of options associated with them. Calendar Spread–  Simultaneously establishing  long and short options positions on the same underlying stock with different expiration dates. For example, you buy the December, 2010 $20 call and sell the April, 2010 $20 call on the same equity. Horizontal Spread– A  spread where both options have the same strike price as in the above example but different expiration dates. The terms calendar and horizontal spreads are interchangeable. Diagonal Spread– A long and short options position with different expirations AND strikes. For example, you buy the December $20, 2010 call and sell the April, 2010 $25 call.   Concept behind this strategy: The investor establishes the long option position by purchasing (usually) I-T-M LEAPS and then selling a near-term, slightly O-T-M call, the short position. Trades are constructed such that, if assigned, the difference between the spread ($5 in the above case where the $20 call was bought and the $25 call was sold) + the short premium collected, exceeds the cost of the long option. If unassigned, where the price of the stock does not exceed the strike price of the short call, we then continue to write calls and generate a monthly cash flow. The problem in this second scenario is that if the stock price falls, the premiums generated from the short call drops unless we write for a lower strike, which may result in a loss for this long-term strategy as the spread (difference between the two strikes) declines.   Let’s take a look at the options chain for a highly traded equity, INTC:   INTC currently priced @ $20.43   INTC- Deep I-T-M Calls The January, 2012 $10 strike is purchased for $10.60, $10.43 of which is intrinsic value and only $0.17 is time value. Minimal time value is a characteristic of deep I-T-M LEAPS options. Next let’s check the near-term, slightly O-T-M strikes:   INTC- Near-Term, O-T-M Options   The next month, $21, slightly O-T-M strike can be sold for $0.43. Let’s do the math, if assigned: We collect the difference in the spread ($21 – $10 = $11) + the short option premium = $0.43 for a total of $11.43. We deduct the cost of the long call ($10.60) for a profit of $0.83 per share or $83 per contract. The percentage return is $83/$1060 or 7.8%. All calendar spreads are constructed such that there is a profit if assigned. If the shares are not assigned (price of stock NOT greater than the strike of the short call ($21), our profit is $43/$1060 = 4.1% and we’re free to sell another option. As noted above, this works well as long as the share price does not dramatically decline thereby reducing the returns on the short options. We also must bear in mind that the long call (LEAPS) is a decaying asset and there will become a time when we no longer own the right to purchase INTC at the $10 strike (when the option period expires). If we continue to generate monthly returns of $43, how long will it take us to retrieve the $1060, if never assigned? Here’s the math:

$1060/$43 = 24 months, not counting any difference in the spread.

Our option is good for about 22 months, so if the option ultimately expires worthless and the spread has decreased, we lose! Diagonal spreads work best for rising stocks where we can take advantage of the difference in the original strike prices. Advantages of using LEAPS:

• Less costly than purchasing stock; remaining cash can be used to generate additional cash
• A declining stock will have time to recover
• Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.

  Disadvantages of using LEAPS:

•  You do NOT capture stock dividends
• To stay active, you must sell options in cycles that report earnings, taking on additional risk
• LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
• A higher level of approval will be required by most brokerages to allow this type of trading
• The long calls will ultimately expire, stocks will not
• Forced assignment may not allow for a profitable trade

Conclusion: Purchasing LEAPS and selling a call option on that position is NOT a true covered call write. It is an alternate strategy that has its pros and cons. For most Blue Collar Investors, covered call writing is the better path to take. But to some investors who fully understand the nuances of diagonal spreads, this may be a viable alternative.   California seminar: I’ve been invited to host a presentation for the Los Angeles Chapter of the American Association of Individual Investors.

• Date: Saturday October 19, 2013
• Time: 9AM to 12PM
• Venue: Skirball Center, 2701 N. Sepulueda Blvd

I will post the link to register on this site once the group leadership sends it to me. My next live seminar will be on Tuesday May 14th @ Caesar’s Palace in Las Vegas: http://www.thebluecollarinvestor.com/event/las-vegas-moneyshow-at-caesars-palace/   Market tone: The first quarter, 2013 showed accelerated growth compared to the 4th quarter, 2012 but below expectations. Here is our mixed bag of economic reports that still supports a slowly-recovering economy:

• The annualized growth rate of GDP as reflected in the 1st quarter, 2013 came in @ 2.5%, below the 3.0% expected but well above the annualized 0.4% rate from the 4th quarter, 2012 according to the Commerce Department
• Consumer spending and inventory replenishment accounted for a large portion of the expansion
• Existing home sales declined in march by 0.6% BUT sales are up a whopping 10.3% compared to march, 2012
• Existing home sales have beat year-ago stats for 21 consecutive months and prices have also beat for 13 straight months
• Prices for existing homes rose by 6.4% from February to March with the median price reaching $184,300
• Existing home inventories in March came in @ 4.7 months, 17% below a year ago
• New home sales rose 1.5% in March and are up 18.5% from a year-ago
• The median price of new homes rose 3% to $247,000 in March from $239,800 a year-ago
• Durable goods orders (a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least three years. Durable-goods orders are a leading indicator of industrial production and capital spending.) fell by 5.7% in March more than the 2.8% decline expected
• Orders for core capital goods (a measure of business investment spending) rose by 0.2% in March
• Initial jobless claims for the week ending 4-20-13 came in @ 339,000 better than the 351,000 anticipated

For the week, the S&P 500 rose by 1.7% for a year-to-date return of 11.6%, including dividends.  Summary: IBD: Market in correction BCI: Cautiously bullish favoring in-the-money strikes 3-to-2 My best to all, Alan (alan@thebluecollarinvestor.com) www.thebluecollarinvestor.com