Covered Calls

[gtober]

Covered Calls with LEAPS (as opposed to stocks)

My trading involves lots of covered calls. However, I tend to take a long term perspective on my options. This is opposite to most options strategies, but I like it. In that vein, I thought I would introduce a LEAPS options strategy that is useful for fairly conservative money looking for excellent returns. There is risk of course, but I would say less risk than stocks in general. As well, I am sure this is covered in an options book somewhere, but I have not read it. Just something I have been thinking about.

What we want is a stock that is depressed, and that we feel has excellent rebound prospects. We buy the LEAP as far out as we can. The Strike 2010's right now. Let the stock rebound, and therefore the LEAP increase in value. Then, the covered call strategy kicks in. Use the LEAP in the same way as a stock, and write calls against it.

As example let's say the LEAP was bought for $15 and rebounded to $20. You write a call for $1.50 against the LEAP. What you have done is decrease the cost basis of the LEAP by $1.50 to $13.50. You could allow yourself to be called out for a nice profit and move on. Interactive Brokers will sell the LEAP against the option if assignment is chosen, so it's just like a stock there. Even if your brokerage does not do this, you merely need to manage the position and sell the leap, buy back the call near expiration, when all the time premium is gone. (FWIW, I have not had IB take a LEAP from me on assignment as yet)

Now, assume you want to keep the LEAP. What I propose is that you let most of the options premium dissipate, and you write a calendar spread to roll over the option to the next month's expiration. By rolling over, you gain say $0.50. This has the effect of reducing the LEAP's cost basis to $13.00, and it will still get called out at the same strike price, only one month further out. You can keep doing this until December 2009. (one month before the expiration on the LEAP which is January 2010) That is 20-22 months. If you can get $0.50 per month on each successive calendar spread, you will collect around $10-12 in premiums over the course of the strategy. Your original cost was $15 and your strike is whatever you have been playing with. So, what we are looking at here is a rate of return of around 80% in less than 2 years. In reality, you can get much higher. AAPL for instance, will yield $5-8 per month in time premium.

Once the December 2009 call is written, you are looking to let the position get called away.

This is a fairly conservative strategy for a "buy and hold" type of investment. It has also been very simply explained. There are pitfalls and risks that are inherent in every stock strategy, and it is a bit more risky than a plain old stock-based covered call strategy. However, you don't need to commit the full value of the stock to the strategy. Only the value of the LEAP.

I would be interested in hearing from others what you think; and I am especially related in any pitfalls you might think of.

Thanks.