Covered Calls using LEAPS

adamsc57

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sorry for asking what might have already been answered (just point me to th eanswers)...

Looking to buy LEAP and sell current month (or 1 or 2 month out depending on premium return) option as income :idea:

1. Why do I need to thing about a break-even value on the LEAP if I am never going to exercise the LEAP, and if I get exercised on sold option it gets offset with LEAP so I don't have to buy and sell underlying stock :?:

2. If stock is trading at say $10, can I buy LEAP at say $5 and sell current month at say $7 (both calls are ITM)? Is there a problem with this? I expect to get exercised on the current sold call and offset this with the LEAP :rolleyes:

Hope this makes sense to someone.


Chris
 
sorry for asking what might have already been answered (just point me to th eanswers)...

Looking to buy LEAP and sell current month (or 1 or 2 month out depending on premium return) option as income :idea:

1. Why do I need to thing about a break-even value on the LEAP if I am never going to exercise the LEAP, and if I get exercised on sold option it gets offset with LEAP so I don't have to buy and sell underlying stock :?:

2. If stock is trading at say $10, can I buy LEAP at say $5 and sell current month at say $7 (both calls are ITM)? Is there a problem with this? I expect to get exercised on the current sold call and offset this with the LEAP :rolleyes:

Hope this makes sense to someone.


Chris

This may be a little long winded, but stay with me here....

A simple example:

* Hewlett Packard @ $30.96 (HPQ)
* Buy 07 Jan 22.5 Call @ $9.90 (VHPAX) (used as a surrogate for stock purchase)
* Sell 06 Feb 32.5 Call @ $0.75 (HPQBZ)
* Net debit $9.15 (net cost of trading the two options)
* % If Assigned: 20.5%
* Break Even: $30.42 (break-even at expiration time of the sold option)

Buying a LEAP instead of a stock creates leverage, since a LEAP can be purchased for only 30% of the cost of buying shares of stock. Therefore, this strategy has about 3:1 leverage over the owned equity or cash-secured techniques used for covered calls and naked puts. Because of this extra leverage, Calendar LEAPS are more speculative and provide higher returns or potentially higher losses if the stock moves in the wrong direction. There can be a tendency for investors to overtrade when leverage is available, but this can be avoided by understanding the risk/reward makeup of the strategy.

An investor pays for a LEAPS option and receives income from the call option he sells against the leap (similar to a covered call). An initial debit is created because the cost to buy the LEAP is larger than the income created from the call sold in setting up the position. This net debit is the maximum risk for the spread and the amount you have invested in the position.

The value of this position is very fluid because the value of both options changes every day due to stock price changes, volatility fluctuations, and time decay erosion from both option premiums. But a break-even point can be calculated for the spread given two conditions: First, the short-term option expires, and second, we have to estimate the remaining value of our asset, the LEAPS option.

Once the short-term option expires worthless, you have realized its entire premium. That means the total amount you invested is still the net debit of the position. So break-even would occur when the remaining asset value (the LEAPS option value) equals the amount you invested to own it. Break-even happens at some unknown stock price that would make the LEAPS option value equal to your initial net debit.

In the example described at the beginning of this analysis, if the stock was trading at $30.42 on February expiration, the short option would expire worthless and the long LEAP option would have a theoretical value of $9.15. Break-even would be $30.42 for a stock currently trading at $30.96. The % If Assigned is the maximum potential return that could be made on this spread if the stock is trading at the strike price for the short-term option on its expiration date.

That means the short option would expire worthless and the long LEAP option would have a theoretical value 20.5% above the initial cost (net debit). An investor could sell to close the long option and realize this profit, or sell another short-term option against the LEAP option, lowering the cost basis further. After some months of writing, the investor could own the LEAP option contract with no cost basis.

If the stock is trading above the short-term strike-price (ITM) near expiration, the short option may be assigned. In this scenario the investor could:

1. Buy to close the short option and sell to close the LEAP for profit. Since the delta of the ITM LEAP is greater than the delta of the short option, the rise in stock price will cause the LEAP to gain in value over the short-term obligation (Delta Ratio).

2. Buy shares of stock at market price to deliver the short obligation then sell to close the LEAP. This covers the obligation and allows the investor to take advantage of the time premium remaining on the LEAP. A profit will still be made since the intrinsic difference between the stock purchase and the short strike will be covered by the intrinsic value of the LEAP.

3. Exercise the long LEAP to purchase shares of stock to deliver the short obligation. In the above example this means shares would be purchased at $22.50 and sold at $32.50. This would provide a $10 credit from the difference in strike prices, thus yielding a $0.85 profit over the initial $9.15 debit. A conservative investor will always look for spreads where the net debit is less than the difference in strike prices (Debit / Difference in Strike Price Ratios).

4. Buy to close the short call, closing the obligation then selling another call against the LEAP. This adjusts the initial net debit and potentially leads to higher profits if the stock continues to rise.

:smart:
 
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