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Supercharge Your Covered Calls Using LEAPS

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For some investors, the cost of establishing a covered call position can become prohibitive. For example, with AAPL stock currently trading around $105, an investor would need to have roughly $10,500 in their account in order to make 1 covered call trade on AAPL.

Even if an investor did have that amount in their account, trading 1 AAPL covered call is not what you would call a well diversified portfolio.

Assuming an investor wants a decent level of diversification, they may want to have say 10 stocks in their portfolio over which they are writing covered calls.

covered calls using LEAPs

Depending on the individual stock prices, you’re looking at needing around $80,000 – $100,000. For some people that may not be feasible.

Thankfully there is a way to “rent” shares by using LEAP options rather than buying them outright. LEAP stands for Long term Equity AnticiPation Security and investors can use these in a covered call strategy rather than having to buy the underlying shares.

Trading covered calls over LEAP options is also known as a diagonal spread.

KNOW THE RISKS!

As with any investing strategy it’s important to know the risks, and while it might sound great to be able to trade covered calls without having to buy the stock, it is definitely important to understand the risks of this strategy:

  1. Leverage – Whilst you can implement this strategy with far less capital than buying the stock, the exposure is more or less the same. Losses can be higher in percentage terms due to the inherent leverage in the LEAP option.
  2. You are short a call without owning the underlying. This means that if your call is assigned, you could find yourself short the shares.
  1. LEAP options are subject to time decay.
  1. Options trades can often have higher bid-ask spreads than the stock so it may be slightly costlier to enter this type of trade. This is also true when making adjustments.
  1. More of a downside than a risk is the fact that as a LEAP option owner, you are not entitled to the dividend whereas the owner of the stock would be entitle to the dividend.

Now that we’ve looked at the risks, let’s talk about some of the benefits.

  1. Buying a LEAP requires less capital than buying the stock thereby increasing your leverage and potential profits.
  1. Because you have less capital at risk in the trade, you have less risk in total $ terms. For example, buying 100 shares a $100 stock will cost you $10,000 and that is how much you could lose if the stock goes to zero. However, buying a LEAP option with a strike of $50, might mean you only have to put up $5,200 in capital. This is the most you can lose on the LEAP if the stock goes to zero.
  1. This strategy can be used on index options as well as stock options allowing for further diversification. Index options are European style which reduces the chance of early assignment.

A solid grasp of the risks and benefits of this strategy are essential before an investor employs it within their portfolio.

Let’s look at an example to see if we can further cement some of the key concepts.

Firstly, the covered call. AAPL is currently trading at $110.99 so a typical covered call might look something like this:

AAPL May 2016 Covered Call

Date: April 4th, 2016

Current Price: $110.99

Trade Set Up:

Buy 100 AAPL Shares @ $110.99

Sell 1 AAPL May 20th, 2016 115 call @ $2.36

Capital at Risk: $10,863

Instead of buying the 100 shares, let’s look at how the trade might be set up using a LEAP. Here we are buying the Jan 19th, 2018 $60 Call which means a capital outlay of $5,173. We still bring in $236 in option premium for selling the May 20th call, so in the unlikely event that AAPL goes bankrupt, the most we can lose is $4,937.

AAPL May 2016 Covered Call Using a LEAP

Date: April 4th, 2016

Current Price: $110.99

Trade Set Up:

Buy 1 AAPL Jan 19th, 2018 60 Call @ $51.73

Sell 1 AAPL May 20th, 2016 115 call @ $2.36

Capital at Risk: $4,937

Unless AAPL makes a huge move to the downside, the two trades will have a very similar dollar return, but due to the leverage provided by the LEAP, the percentage returns will be much larger both on the upside and downside.

vol trading made easy

11 Comments
  1. Ronald Emshoff says:

    I just need to say i really appreciate you taking the time to do these informative and educational narratives. I just wish i had half of your experience and wisdom. Keep them coming, Ron

    1. Gavin says:

      You’ll get there Ron. It’s not rocket science, it just takes time.

  2. barry kraynack says:

    would you not add a put as well for some extra protection in case of a major drop in a stock for some unexpeted reason?

    would you use some call/put calendars for earnings or do you just stay away from them altogether?

    1. Gavin says:

      Good point Barry. Adding some out-of-the-money puts would be a good idea for some insurance / protection.

      You could do calendars to hedge some of the earnings risk, but it wouldn’t be my preference.

  3. Karsten says:

    just the right posting that I was looking for, Thank You!
    Could u pls attend the strategy if u will be assigned with AAPL stocks ?
    The LEAPS will not cover automatically the assignment, right?

    1. Gavin says:

      Correct, the LEAPs will not automatically cover the assignment.

  4. Fernando says:

    The payoff diagram from this trade looks rather uninviting, as you significantly limit your upside for a meagre 2 1/2 bucks, while maintaining a quite large downside. Check out a bullish RIsk Reversal on SPX options to see the difference, here you benefit from selling an ‘expensive’ put in implied volatility terms, while buying a ‘cheap’ call, where the strike is much closer to the money for the same premium. SPX has to go down by double the amount of points for you to enter the loss zone as it needs to go up for you to enter the gain zone. That’s gives you a good payoff diagram.

    1. Gavin says:

      Hi Fernando,

      Yes I like Risk Reversals and they would suit certain investors. Covered calls tend to focus on income generation whereas risk reversals are looking for capital gains. Thanks for sharing.

  5. Paul says:

    Because we don’t own stock, I’m a little concerned about getting assigned if APPL breaks above the short strike. I haven’t experienced this before.

    To mitigate this risk when using LEAPs, would you consider selling your call a little further out of the money? Maybe you could go out some way further, to reduce the risk of assignment, but still get a superior return on capital invested than applying this strategy by selling the 115 call against straight stock? Would that allow the LEAPs more room to accrue value too because of the higher sold strike?

    Also just enquiring if those LEAPs will have a delta of 1 because they have so much time to expiry?

    Thanks for your article Gavin. You always get me thinking.

    1. Gavin says:

      Hi Paul,

      Nice to hear from you.

      Yes, you could go further out of the money to reduce the risk of assignment. You should try and roll the calls before they become in the money. Refer to the previous articles on exit strategies.

      The LEAPs have a delta of 1 because they are so far in the money.

      G.

  6. Ron Miller says:

    I think you glossed over time decay which has a significant impact on using leaps instead of shares. To me, the reason why you would want to use a leap in this strategy is for the extrinsic value. It would seem appropriate to me that this article also then focus on that as well.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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