Covered Calls Using LEAPS

[cwelsh 1,551]

Well, after being inundated today on posts and PMs, here is some basics on covered calls using DITM LEAPS.

First, why would we use a LEAP for a covered call using DITM LEAPS, as opposed to just buying the stock outright? Simple -- higher returns using the leverage of options. For this example, we'll use AAPL, using last Thursday's prices.

AAPL cost $663.

You could sell the weekly call (making it a covered call), at the following strikes/prices:

660 $10.50

665 $7.80

670 $5.60

675 $3.95

At this point you want to allow some room for upside, so you pick the 670 strike. What are the possible outcomes?

1. AAPL stays the same, you earn $5.60 on the covered call, or 0.84% (yes less than 1%, but remember it is weekly);

2. AAPL goes up, but stays under 670, lets say to 669. At this point you keep the $5.60 in premium, and your stock has appreciated (a good thing). If you were to exit, you would have a gain of $11.60 ($6 in capital gain, $5.60 in premium), or 1.749%;

3. AAPL goes up, above 670. Well this is the same result as number two, except your stock would get called away at 670. So it doesn't matter how much it goes up in price, it still would get called away at 670. So your maximum gain is $12.60 (let's not consider rolling yet);

4. AAPL goes down. Well you again keep the premium, but lose value in the underlying stock.

Why CAN (not necessarily, but why can) using LEAPS be better? Well you can do the same strategy for "cheaper" (the cost being higher risk in terms of losses -- as discussed further below). For starters, to sell a call on AAPPL requires you to own at least 100 shares, at a cost of $66,300.00.

Let's instead look at the Apr 2013 600 option. That can be purchased for $101.00. I typically would go further DITM, to get my delta closer to 1, but for this example, we'll stay at 600 to keep the math simple.

For the price of $10,100.00 you can own the equivalent position as outlaying $66,300.00. But you can get the same amount of premium selling the weekly option short. In other words, I still get $5.60 for selling the weekly 670. So my return is now 5.54% per week instead of under one percent. Over the course of an entire year, this is the difference in turning $10,000.00 into $165,000.00 and turning that same $10,000.00 into $15,549.00. (compound interest is fun).

(side note -- that won't happen -- don't expect it -- it won't). Still that difference gives you the flexibility needed to make the trade worthwhile.

So what are the outcomes of selling against a LEAP, as opposed to just the stock? If the price stays the same, or rises, the outcome is just as good, if not better, than owning the stock.

1. AAPL stays the same -- keep the premium, return 5.54%, theta is basically zero, so gain;

2. AAPL increases, but to under 670 -- again the same result, keep the premium, and keep the gain in the April call. However, the gain in the april call well be more than just owning the stock on a percentage basis. Let's say the price goes up to the same 669. You keep the $5.60 in premium and the call option has increased in value by $6.00, so now $107.00. So you've gained the same $11.60 on $101 instead of on $663 -- a much better situation.

3. AAPL increases above 670 -- well your gains are capped at $12 (rolling will be discussed later)

At this point, this seems like the perfect trade. Unfortunately it is not -- dealing with losses is also leveraged up. If the price of AAPL falls 50 points when you own AAPL, you're looking at a 7.5% loss ((663-50)/663)), whereas you're looking at a FIFTY PERCENT loss on owning the LEAP ($101 - $50 = $51).

So, before ever entering this type of trade, realize the potential losses are MUCH larger than in just owning the stock itself. The returns are also much larger -- that's the power of options.

Part 2 of this column will discuss how to handle the trade when it starts moving against you. A preliminary suggestion though -- always known when you are going to get out and at what levels and stick to those loss points. If you say I can take a 25% loss on this trade, get out at that point, don't hold "hoping" for the price to rebound).

[Rogers 263]

I am pretty new to this but have started using some covered calls in my 401k. I know you can collar the stock by also buying a put at the same time as selling the call.. I suppose while providing some downside protection it would also limit your upside?

[Stephen 4]

Looking forward to part 2.

[tjlocke99 18]

I am pretty new to this but have started using some covered calls in my 401k. I know you can collar the stock by also buying a put at the same time as selling the call.. I suppose while providing some downside protection it would also limit your upside?

Interesting point Scott. So in this case maybe you'd buy the $640 weekly put for $2.50?

[tjlocke99 18]

I think most of the answer to post #2 was actually captured in my original question in this area:

http://steadyoptions.com/forum/topic/624-covered-calls-and-synthetic-covered-calls/page__hl__synthetic#entry11374

Edited October 30, 2012 by tjlocke99

[cwelsh 1,551]

I am pretty new to this but have started using some covered calls in my 401k. I know you can collar the stock by also buying a put at the same time as selling the call.. I suppose while providing some downside protection it would also limit your upside?

Exactly correct -- it's been my experience, if you buy a collar that actually stands a chance of helping, then you're profits will be cut by at least 50%.

Though in the case o f AAPL -- it would have been a good idea.

As a brief update of the AAPL trade --

obviously it's not going as planned. Last Friday, when AAPL dropped below 600 briefly, I elected to double my position size, on the 600 call, and it "reduced" my break even down to $645 (including the weekly premium's I've been taking out). With 8 weeks left before the position closes as long as (a) I keep getting $5 or more per week (hasn't been a problem yet) and ( AAPL stays at 590 or higher, I'll still make money -- albeit not much.

For those wondering where the 585 comes from -- option calculator. Eight weeks of $5 premium gets me $40, lowering the BE to $605. I have the Dec 600, so that would "seem" to be a $5.00 loss. Well, on the day the option expires it would be. But with two weeks left before expiration, after a continued decline, the 590 option should be worth around $25.00. (590+25=605).

If AAPL significant rebounds (or even into the 650 range), this trade can still turn 10%.

If you hate this bumpy ride, a collar is a good idea. I'll try to put something up on that in part two when I can get it written.

[tjlocke99 18]

Exactly correct -- it's been my experience, if you buy a collar that actually stands a chance of helping, then you're profits will be cut by at least 50%.

Though in the case o f AAPL -- it would have been a good idea.

As a brief update of the AAPL trade --

obviously it's not going as planned. Last Friday, when AAPL dropped below 600 briefly, I elected to double my position size, on the 600 call, and it "reduced" my break even down to $645 (including the weekly premium's I've been taking out). With 8 weeks left before the position closes as long as (a) I keep getting $5 or more per week (hasn't been a problem yet) and ( AAPL stays at 590 or higher, I'll still make money -- albeit not much.

For those wondering where the 585 comes from -- option calculator. Eight weeks of $5 premium gets me $40, lowering the BE to $605. I have the Dec 600, so that would "seem" to be a $5.00 loss. Well, on the day the option expires it would be. But with two weeks left before expiration, after a continued decline, the 590 option should be worth around $25.00. (590+25=605).

If AAPL significant rebounds (or even into the 650 range), this trade can still turn 10%.

If you hate this bumpy ride, a collar is a good idea. I'll try to put something up on that in part two when I can get it written.

Chris,

I think the advantage of the collar is that deep OTM options supposedly have less decay as a % of the option price in the last 30 days then nearer ATM options. So you could hold an OTM put with less decay and get the protection if there is a catastrophic drop.

Anyway, another option on this trade is to look at a weekly short strike $5-10 OTM instead of around $10-15.

All this being said, what about your long ITM longer dated Guts strangle and selling the shorter dated strangle like you have mentioned on MSFT, GS and SNDK?

[tjlocke99 18]

Exactly correct -- it's been my experience, if you buy a collar that actually stands a chance of helping, then you're profits will be cut by at least 50%.

Though in the case o f AAPL -- it would have been a good idea.

As a brief update of the AAPL trade --

obviously it's not going as planned. Last Friday, when AAPL dropped below 600 briefly, I elected to double my position size, on the 600 call, and it "reduced" my break even down to $645 (including the weekly premium's I've been taking out). With 8 weeks left before the position closes as long as (a) I keep getting $5 or more per week (hasn't been a problem yet) and ( AAPL stays at 590 or higher, I'll still make money -- albeit not much.

For those wondering where the 585 comes from -- option calculator. Eight weeks of $5 premium gets me $40, lowering the BE to $605. I have the Dec 600, so that would "seem" to be a $5.00 loss. Well, on the day the option expires it would be. But with two weeks left before expiration, after a continued decline, the 590 option should be worth around $25.00. (590+25=605).

If AAPL significant rebounds (or even into the 650 range), this trade can still turn 10%.

If you hate this bumpy ride, a collar is a good idea. I'll try to put something up on that in part two when I can get it written.

Chris,

You know after this hurricane experience, holding a few short AAPL weekly calls going into a Friday scares me. Forget losing an Internet connection, if they close the markets again on a Friday for whatever reason (natural disasters, man made disaster, etc.) but allow exercising then the short holder could get crushed!

[cwelsh 1,551]

Chris,

You know after this hurricane experience, holding a few short AAPL weekly calls going into a Friday scares me. Forget losing an Internet connection, if they close the markets again on a Friday for whatever reason (natural disasters, man made disaster, etc.) but allow exercising then the short holder could get crushed!

I'm not sure they would allow exercise on options that haven't traded for several days, that would be quite surprising (but it certainly could happen). Also, don't forget the position is hedged -- you have the long call at 600. So if someone exercised your short 650 call for example, and you couldn't cover it, you could always sell the long position to cover it (which as long as there is theta left in it and the strike is below your short position, will permit you to cover).

For example, the 600 Call last Friday was worth about $52. If you were short, lets say the 630 call, and it got exercised on Monday, you now are SHORT 100 shares of apple and received $63,000. What are the scenarios when the markets open back up?

AAPL goes down -- well your profits skyrocket at this point, you're short after all. If this had actually happened to you, today you could close the short position at 592 -- or a 3,800 profit (much better than the 500 we'd been making selling the short weekly);

AAPL stays about the same -- well you can just exit, buying AAPL back at the anywhere between its Friday value and 630 and make money.

AAPL moves above 630 a little -- hopefully you have enough cash, and can just close (let's say AAPL went to 640), then you have a loss of $500. (640-630-5 premium received). Bad, but not horrible.

Now the worst case -- AAPL SPIKES -- let's say it goes all the way back up the 710. Well you're now losing $8000 -- ouch. EXCEPT your long position has also gone up by that same amount, since at that level, the delta would be about .80. So your long position which was worth $52 is now (approximately) worth about $120. That's still about a $10 loss per share ($1,0000 on the contract), but again, not the worlds worst case scenario.

That's why you have to have the long position in there

[cwelsh 1,551]

Chris,

I think the advantage of the collar is that deep OTM options supposedly have less decay as a % of the option price in the last 30 days then nearer ATM options. So you could hold an OTM put with less decay and get the protection if there is a catastrophic drop.

Anyway, another option on this trade is to look at a weekly short strike $5-10 OTM instead of around $10-15.

All this being said, what about your long ITM longer dated Guts strangle and selling the shorter dated strangle like you have mentioned on MSFT, GS and SNDK?

I most certainly am opening a longer dated guts trade with AAPL -- its one of the better candidates and I'll have a post on it shortly.

[Rogers 263]

Hi Chris,

Not sure if this is the appropriate forum for this or not.. With the market down 10% and the future direction uncertain (year end rally, fiscal cliff crash) how are you positioning your shorts on your covered call trades? ATM for a little downside protection, OTM so you can capture a little upside rally or ITM because you might be expecting a further pullback? I run covered calls in my retirement funds and most of them are about 10% OTM right now with little premium because they are due on 1/19/13

My first thought is to leave them alone

[cwelsh 1,551]

I'm slightly OTM on most of the weekly ones -- I almost never price ITM on covered calls -- my goal is to only have the underlying called away in the event of a large profit.

I run my CC's either weekly or monthly -- rarely out to January. Without knowing more, if they are 10% OTM I would either (a) leave them alone or ( buy them back and start selling in a closer time frame. I certainly wouldn't move them ITM (particularly if your underlying is down).

[tjlocke99 18]

Hi Chris,

Not sure if this is the appropriate forum for this or not.. With the market down 10% and the future direction uncertain (year end rally, fiscal cliff crash) how are you positioning your shorts on your covered call trades? ATM for a little downside protection, OTM so you can capture a little upside rally or ITM because you might be expecting a further pullback? I run covered calls in my retirement funds and most of them are about 10% OTM right now with little premium because they are due on 1/19/13

My first thought is to leave them alone

Scott,

Check out Kim's stock repair strategy referenced here. I am considering doing this myself.

http://steadyoptions.com/forum/topic/422-csco-my-idea/page__hl__+stock%20+repair%20+strategy#entry14391

[Rogers 263]

My IRA account is restricted to level one options only.. single calls/put and covered calls.

[cwelsh 1,551]

Get a new ira account

Oh, and for those wondering about my "AAPL" trade -- I closed it a week or so ago for a horrific loss. Single worst trade in about two years -- the trade itself lost about 60% of its value -- good times.