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Selling LEAPS - Not as Attractive as Short-term Options

The LEAPS (long-term equity appreciation securities) is an option that does not expire for as long away as 30 months or so, but is it a better alternative than shorter-expiring contracts? Traders selling covered calls may be attracted to the premium of 11 on an ATM strike, versus the less appealing 1.5 on a 2-week contract.

The question here is: What is better, 11 or 1.5?

Many will be surprised at the answer: 1.5 is better. Yes, $150 is preferable to $1,100, given the time to expiration. To illustrate this point, consider three LEAPS short options, all on Chevron (CVX) and based on the closing price as of February 12. The stock closed that day at $92.55, so the comparison is made between 92.50 calls for different expiration dates. Assuming a covered call is the selected strategy, the bid prices of calls for these three options are shown below:

  • January 21, 2022 (342 days)   92.50 call bid 9.90. Based on current stock price, the return is:
    9.90 ÷ 92.55 = 10.70%
  • June 17, 2022 (489 days)    92.50 call bid 11.10. Based on current stock price, the return is:
    11.10 ÷ 92.55 = 11.99%
  • January 20, 2023 (706 days)   92.50 call bid 11.25. Based on current stock price, the return is:
    11.25 ÷ 92.55 = 12.16%


These returns seem healthy enough. All are in double digits. The problem is that the positions must be held open for such a long period of time (11 months, 16 months, and 23.5 months). This not only ties up a trader’s capital, but it also prevents taking other opportunities that might arise during this length holding period. The dollar value of these calls is healthy, but when the returns are annualized (restated as though the holding period were exactly one year), the true yield is not as positive:

  • January 21, 2022 (342 days)   10.70% ÷ 342 days * 365 days = 11.42%
  • June 17, 2022 (489 days)        11.99% ÷ 489 days * 365 days = 8.95%
  • January 20, 2023 (706 days)    12.16% ÷ 706 days * 365 days = 6.29%


These returns are still not that bad, but compared to shorter-term covered calls, they are dismal. For example, based on the CVX price at the close of February 12, consider three options expiring within one month, both for initial return and annualized return:

  • February 26, 2021 (13 days)   1.54 ÷ 92.55 = 1.66% 
    Annualized: 1.66% ÷ 13 days * 365 days = 46.61%
  • March 5, 2021 (20 days)          2.12 ÷ 92.55 = 2.29%
    Annualized:  2.29% ÷ 20 days * 365 days = 41.79%
  • March 12, 2021 (27 days)        2.44 ÷ 92.55 = 2.64%
    Annualized:  2.64% ÷ 27 days * 365 days = 35.69%


From this summary, it is apparent that the shorter-term covered calls are more profitable on an annualized basis than any of the LEAPS contracts. If a trader were to write one 2-week covered call 26 times over the coming year, as close to the money as possible, the overall net return would be far higher than writing one call for one to two years out.

There are other advantages to taking in a stream of relatively small dollar amounts rather than using the LEAPS calls. The longer-term covered calls will be less responsive to intrinsic value changes, than short-term contracts. Of even more importance, with the 2-week option, time delay will be rapid, and chances for profitability are much higher. As expiration approaches, time decay accelerates, especially during the final week. For example, between the Friday before expiration and the Monday or expiration week, only one trading day passes; but three days of time decay occur. On average, options lose one-third of their time value between these three days.

Writing options every two weeks demands close monitoring to avoid exercise if the underlying price moves the option in the money. In this event, the option can be closed or rolled. The act of rolling forward is not part of the ideal plan for achieving the double-digit returns gained by a high volume of covered call writing. It could be preferable to accept exercise, meaning the premium is all profit, and the trader can then purchase another 100 shares, either of the same underlying or another one, and begin the covered call writing process over again.

An expansion of the short-term covered call strategy is to use the ratio write. In this approach, more calls are sold than can be covered. For example, a trader owns 200 shares and sells 3 calls at the money. It may be viewed as two covered and one uncovered call, or as three partially covered calls. This is a moderate risk strategy. It generates more income than the one-to-one covered call, but risks exercise as well.

To modify the risk, the variable ratio write is a sensible alternative. In this case, two strikes are used. For example, a trader owns 200 shares  at $92.55 per share. A variable ratio write is opened combining two 92.50 calls and one 95 call. The OTM call can be closed if the underlying price begins to rise, and if the two-week approach is used, chances are good that this will result in a small profit or breakeven. The less volatile the underlying, the lower the risk, and the lower the premium a trader will receive. This requires a balancing act between risk and reward (as all options trades do).

Being aware of how annualized return will change perceptions about covered calls, and which ones are most profitable. Many novice traders go immediately to the longest-term LEAPS they can find, attracted by the much higher premium. When the math is studied and the true annualized returns are compared, short-term options make more sense.

The overall return is further enhanced when the underlying pays an exceptional dividend. For example, CVX yields a dividend of 5.16% per year. This by itself is impressive, but when added to the annualized yield of covered calls, it is irresistible. For example, the 13-day option in the previous example yielded annualized return of 46.61%. Adding the dividend of 5.16%, the overall net return is 51.77%. That is a difficult level of net return to match anywhere else.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.  



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