Covered calls are a great strategy for reducing account volatility and earning income on your long stock positions. On the Learning Markets website We have also talked about using LEAPS options as a way to “lease” stocks for less money than it costs to acquire the stock outright.
Is there a way to combine the benefits of these two investing strategies to get the best of both worlds? Yes there is by selling covered calls against a long LEAPS option position, also known as diagonal spreads.
Here are a few of the key concepts to keep in mind when trading a covered call on a LEAPS option:
Risks
1. You are short a call without an underlying stock position. This means that if you are “called out” you could find yourself short the stock.
2. A LEAPS option has time value that is melting each day as you near expiration.
3. Option trades are often at a higher commission rate and this will increase your trading costs.
The benefits of trading a covered call on a LEAPS option are also very significant. I have outlined a few of those in the list below:
Benefits
1. The LEAPS contract is cheaper than the underlying stock and that increases your leverage and potential profits
2. Because the LEAPS contract is cheaper you have less risk in absolute dollar terms than holding the underlying stock
3. This is a strategy that can be used with index options as well as stocks and ETFs
4. Using it on index options with European style expiration eliminates the slight possibility of early exercise
Balance the risks and benefits to decide whether this strategy works for you and to help you decide the best way to implement it within your portfolio. As we release this series of articles I will use a case study to illustrate the concepts. Repeat the steps in the case study on an option of your choice in a paper trade. Repeating the method yourself will help you understand the strategy and remember how it works.
Part Two – Steps for entering a diagonal spread trade.
In the second part of this article on selling covered calls against LEAPS or diagonal spreads I will begin walking through the entry process with a case study. The numbers and real life scenario should help you understand how these trades work and why they are attractive but if you really want to remember the information you should paper trade it a few times yourself. Going through the process by hand will help you remember the process.
In the case study I will use an index option with European style expiration. This solves the problem of early exercise that I mentioned in the first part above. Because European style options can only be exercised at expiration and not before. The index option I will use is the Mini SPX Index Option (XPS.) The XPS or mini version of the SPX is good for smaller traders as the options are only 1/10 the price of the normal SPX options.
Step 1: Buy the long term option
First, we need to buy the long term option at least a year out before expiration. In the case study this means buying the December 2009 calls.
The long term options purchased can be very far in the money if you wish, but I typically suggest buying one strike price in the money. Assuming a current XSP price of $93 that means I would buy the $90 strike price calls for $1,615 per contract.
Step 2: Selling the short term option
In my experience, buying a far in the money long term call does not materially impact returns compared to a call that is very near to the at the money strike price.
What is important however, is that in the next step you sell a short term call with a strike price ABOVE or further out of the money than the call you bought. In this case, that means I would sell the December 2008 95 strike price calls for $535 per contract. The rate of return just based on those prices is more than 30%. Of course, risk and time value will eat away at that best case scenario.
At this point the trade looks very similar to a covered call. The long term option takes the place of the long stock and protects against the unlimited losses that may occur with a short option alone. In the next section I will cover what happens if you are “called out” of a trade like this at expiration.
Part Three – How to deal with expiration when trading diagonal spreads.
Diagonal spreads can lead to interesting problems at expiration if the short call is in the money. There are a three concepts you should be aware of when dealing with an in the money short call and this article will discuss these concepts and their affects on the case study used in the video. Keep in mind that like a true covered call, if the short option expires out of the money there are no additional actions needed, but you will get to keep the entire premium.
American Style Stock Options:
Most options on stocks and ETFs are American style expiration which means that if your short call is in the money it can be exercised at any time. Although early exercise is rare it does happen.
If the option is in the money at expiration it will most likely be exercised. Because you don’t actually own the stock when you are exercised your broker will probably short the stock in your account. If you are not prepared for this you should avoid selling or writing American style options.
European Style Index Option:
In this series we used an European style index option on the XPS. This style of execution means that you cannot be exercised early.
If the option is in the money you may need to take some action by expiration but you don’t need to take action before that time. If you do not want to be exercised at expiration you will need to buy the option back at its current market price before expiration.
Cash Settlement:
Most European style index options like the SPX or XSP are cash settled. That means that if at expiration the option has a value of $100 you will have $100 withdrawn from your account to pay for the “exercise.” If you had been long that option when it expired you would have had the $100 deposited in your account.
These options are cash settled because there is no underlying stock. They represent an index rather than a real stock and therefore you don’t have a potential short stock position like you might with an American Style option.
In the next section we will talk about what happens if the market declines. This is good for the short call position because it is more likely to expire out of the money and you get to keep the entire premium. However, there will be losses on the long term call. We will cover when you should consider exiting the entire position and reenter after a larger drop in the underlying stock or the index.
Part Four – How to make adjustments to your spread when the market does not go your way
One of the most significant benefits of covered calls or diagonal spreads is the hedged position it creates. The premium from the short call offsets some or all of the losses on the long call with the further expiration if prices drop. I am convinced that managing risk as a trader is one of the most important things we can do, which makes diagonal spreads or covered calls on LEAPS a very attractive strategy.
The risk management within this trade can help to put you one step ahead of market volatility. In the video I will go over what happens to this trade when prices drop, which may not be the worst result. If the short call expires out of the money you will keep the entire premium and owe nothing. However, the long call will have sustained losses. It may become necessary to sell the long call and reconstruct the trade with a new in the money long term option or LEAPS call before you sell another call in the short term.