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LEAPS As Stock Surrogates And Covered Call Writing

LEAPS are long-term options with expirations usually greater than 1 year.

using LEAPS when covered call writing

LEAPS are long-term options

Some investors buy LEAPS instead of stocks to then write covered calls on this leveraged type of security. This is related to, but not recisely the same, as traditional covered call writing. The best term to describe this strategy is called a calendar spread where you simultaneously establish long and short options positions on the same underlying stock with different expiration dates.

Here’s how the strategy is set up:

  • Buy deep-in-the-money LEAPS for company BCI
  • Sell near-term (I prefer 1-month) options
  • Construct such that, if exercised, the difference between the strikes + the premium collected is > the cost of the LEAPS option
  • If unassigned, continue to write short term call options

 

Traditional calculations for max return

  • Buy BCI @ $35
  • Sell the $37.50 near-term call @ $1.50
  • Maximum profit if BCI closes at or above $37.50 @ expiration
  • $150 (option premium) + $250 (stock appreciation) = $400
  • $400/$3500 = 11.4%, 1-month return

LEAPS calculations for max return

  • Buy $25 in-the-money LEAPS for BCI @ $10
  • Sell the 1-month $37.50 call @ $1.50
  • Maximum profit if BCI closes at or above $37.50
  • $150 (options premium) + $1250 (difference between strikes) – $1000 (cost of 1 LEAPS contract) = $400
  • $400/$1000 = 40% (+ any time value remaining on LEAPS)

 

Traditional calculations if stock closes @ $30

  • Unrealized loss of $5 from share depreciation
  • Profit of $1.50 from sale of option
  • Loss of $350 per contract
  • $350/$3500 = 10% loss

LEAPS calculations if stock closes @ $30

  • LEAPS value declines by $5 (intrinsic value)
  • Option profit = $1.50
  • $350/$1000 = 35% loss (less any time value remaining on LEAPS)

Advantages of LEAPS strategy

  • Lower cost basis leads to higher return on investment (ROI)
  • Pay no interest compared to leveraging via margin accounts (interest rates can also increase)
  • Less likely to panic and close out a declining stock since max loss is cost of LEAPS minus option premium
  • Ties up less capital
  • Less downside risk

 

Disadvantages of LEAPS strategy

  • Smaller pool of stocks to select from
  • You do NOT capture stock dividends
  • To stay active, you must sell options in cycles that report earnings, taking on additional risk
  • LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
  • A higher level of trading approval will be required by most brokerages to allow this type of trading
  • The long calls will ultimately expire and lose value as expiration approaches, stocks will not
  • Forced assignment may not allow for a profitable trade
  • Wide bid-ask spreads due to the difficulty of pricing securities so far out
  • Long-term commitment-may be a high cost to close
  • Variability of return: LEAPS do not behave precisely as stocks
  • Less likely to be approved for sheltered accounts

Summary

There are many ways to generate profits in the stock market and using LEAPS as stock surrogates when using a covered call writing-like strategy is one of them. This strategy is a bit more complicated than traditional covered call writing (my personal preference) and has its pros and cons. Each aspect of the strategy should be mastered before considering risking your hard-earned money employing it.

Update:

Many of our members have asked me if I was hosting a seminar at The Las Vegas Money Show this month. The folks at The Money Show were generous enough to invite me to speak at this great event but I had a previous commitment to host a private webinar in May. I also wanted to devote a solid month and a half to finishing my 5th book relating to selling cash-secured puts, a book many of you have been asking for. This week I completed the first draft and expect to have the book published before the end of the year.

Thanks to your incredible support, The Blue Collar Investor has been growing faster and stronger than we ever believed possible. That has attracted many other experts to request to do joint ventures with us that will allow us to provide more and enhanced information and tools for our members. Keep an eye on this site as we expect to be making several exciting announcements regarding these enhancements in the near future.

My next live seminar will be in Orange County, California on June 14th. I’ll provide a link once I receive it from the investment club.

 

Market tone:

Improving jobs data highlighted this week’s reports:

  • The economy added 288,000 jobs in April, 78,000 more than expected
  • The unemployment rate dropped from 6.7% in March to 6.3% in April. Economists were expecting a rate of 6.6%
  • The number of people out of work long-term also dropped by 287,000
  • 1st quarter GDP rose by an annual rate of 0.1%, below expectations (+1.3%)
  • The Conference Board’s Index of Consumer confidence came in @ 82.3 below the expected 83.0 but 4 points higher than February’s mark 0f 78.3 and 10.3 above November’s low of 72.0
  • Employment compensation rose by 0.3% for the 1st quarter according to the Labor Department, below expectations (0.5%)
  • The Commerce Department reported a 0.5% increase in personal income for March above expectations (0.4%)
  • Personal spending increased by 0.9% above economists projections (0.6%)
  • The Fed announced it would continue its bond-buying tapering by $10 billion
  • The Fed will keep federal funds rate to 0 – 0.25% as long as inflation remains under 2%
  • The ISM Manufacturing Index rose for the 11th consecutive month in April to 54.9% (54.2% expected)
  • In March, new orders for manufactured goods was up 1.1%, after a 1.5% gain in February
  • The Commerce Department reported a 0.2% increase in construction spending, below expectations (0.6%). Spending, however, was 8.4% higher than March, 2013

For the week, the S&P 500 was up 1% for a year-to-date return of 2.4%, including dividends.

Summary:

IBD: Market in correction

BCI: We have a choppy but stubbornly-holding stock market with mostly favorable economic reports and positive earnings for our corporations once again. This site remains moderately bullish and selling an equal number of in-the-money and out-of-the-money call options.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

14 Responses to “LEAPS As Stock Surrogates And Covered Call Writing”

  1. Barry B May 3, 2014 5:03 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 05-02-14.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
    http://www.youtube.com/user/BlueCollarInvestor

    We are in Earnings Season (although near the end), be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    You will also notice that we changed the second and third sections of the report. We separated the symbol and the number of weeks on the Running list for better clarity and easier copying for those who use the third section to copy the Running List into their own purpose built spreadsheets. The suggestion for the change came from one our Premium Members.

    Thank you Jared.

    Best,
    Barry and The BCI Team

  2. Dave May 4, 2014 7:34 am #

    Alan,

    I understand “in the money”, “out of the money”, “upside potential”, “downside protection”, etc. All good. It hit me as I did my calculations that the strike price is very close to the stock price in these picks. So to go back to the basic principles of covered call writing a la BCI: 1) do no harm (risk considerations first) and 2) make money with singles and doubles. In this “perfect” covered call market, is the best first tactic to pick a strike price close to the stock price. Through all the definitions, I’m not sure I ever saw this discussed, but I could have easily missed it.

    Thanks for your time and help and for BCI!

    Dave

    • Alan Ellman May 4, 2014 7:44 am #

      Dave,

      The closer your stike is to an ATM strike, the greater the time value initial profit will be. It is very important to take advantage of overall market assessment and chart technicals to select the most appropriate strike price. This is one of the key factors that make BCI members more successful than most others. Here are the main factors we use to determine strike price selection:

      Market assessment
      Chart technicals
      Personal risk tolerance

      The first task at hand is to determine what your initial goal is for generating option profit…mine is 2-4% per month. In my mother’s account I use a more conservative 1-2% with ETFs.

      From there, the more bearish you are the deeper ITM you go. The more bullish, the deeper OTM you go. These are guidelines, not hard-and-fast rules.

      For much more detailed information on strike price selection refer to pages 108 – 124 in The Complete Encyclopedia for Covered Call Writing…lots of examples to review.

      Alan

  3. Baruch May 4, 2014 10:41 am #

    I have used this strategy fairly successfully however I would like to point out that you should try and find leaps with 0.80 or if possible 0.90. You will benefit in a few ways. You will be buying less time value (theta) and you will have an option that moves more like a stock. The only drawback will be that it will be more expensive but of course your chance of success will be much higher

  4. Alan Ellman May 4, 2014 12:50 pm #

    From Richard B of Milwaukee:

    Try using a call with an .80-.90 delta about 9 months out.

  5. Dan May 5, 2014 7:21 am #

    Hi Alan,

    I have been with BCI for about seven months now and am very happy with the service.

    Lately I have been educating myself on technical analysis and I now realize that there are definite advantages to entering a trade as close to (or below) the moving average as possible.

    In the past I have just taken your covered-call stock suggestions and bought them without thinking about moving averages. I never tried to “time the buys”.

    Questions:

    1) Do you personally try to wait for your buys so that you are buying close to the moving average of the stock? Or do you just buy them and not think about the timing?

    2) If you do time your buys, do you use MA or EMA and what number of days do you commonly use?

    Comments:

    When I think about “timing the buys”, two thoughts come to my mind (from a covered-call perspective)

    · It may take days to get a good timed buy, and I may be sacrificing part of my covered call premium (time value) waiting for the buy

    · If the current price of the stock is above the MA, perhaps I will get a better premium for the covered-call…which then could possibly offset the difference between the stock price and the moving average.

    Can you please give me some feedback on the questions and comments?

    Best regards,

    Dan

  6. Alan Ellman May 5, 2014 7:35 am #

    Dan,

    I am a big believer in technical analysis as you are. It represents one third of our analysis screens for stock selection. Timing the market for a 4 or 5 week obligation is quite a challenge. We may be right and we may be wrong. Waiting, because of the effect of theta, will definitely result in time value erosion of our option premiums.

    As a guideline, I like to enter my trades in the first few days of a 4-week contract and within the first 7 days of a 5-week contract, the earlier the better.

    In a sense, we do time our trades to the extent that we have eligible stocks with uptrending EMAs and price bars at or above the 20-d EMA. We also look at momentum indicators with MACD histogram and the stochastic oscillator. Positive trend and positive momentum.

    Should your chart analysis concern you that perhaps the trend is about to reverse in the current contract period, you could use in-the-money strikes to generate income that meets your goal and have that downside protection (I call it an insurance policy paid for my the option buyer) in the form of intrinsic value.

    Our BCI screening process includes 20-day and 100-d EMAs. This will give us a quicker look at changes in trend than we get from SMA.

    Finally, as far as premium is concerned, the main 2 factors are time to expiration and the implied volatility of the underlying security.

    Waiting tio enter positions may be more appropriate for longer-term investing. Structuring our strike prices to reflect our chart analysis and personal risk tolerance makes a lot of sense.

    Alan

  7. Ron May 5, 2014 1:29 pm #

    Hi Alan,

    I have just realized something significantly wrong with my thinking that Short Puts are like Buy/Write calls.

    With a short put there really is no downside protection since the cost to exit, should the underlying price decline, is higher. At the same time with a covered call the premium has declined by the time the underlying falls to the strike price. So I can prevent a loss just by setting a stop on both the stock and the option at the strike price of the call.

    I’d like your thoughts on this.

    Ron

    • Alan Ellman May 5, 2014 1:32 pm #

      Ron,

      1- Depending on your definition, I believe there is downside protection when selling OTM puts:

      Stock @ $42
      Sell OTM $40 put for $1.50 = $150/contract
      Cash to secure put = $4000.00
      1-month initial return = 3.75%
      That profit is guaranteed as long as the price remains above $40
      Downside protection = $2/$42 = 4.8%
      We are guaranteed a 3.75%, 1-month return as long as share depreciation is not greater than 4.8% by expiration.

      I am currently writing abook about put-selling because of member demand. Should be available in a few months.

      2- Setting a stop on the long stock and short call option may not prevent a loss. If you sold an ITM strike and the price drops to the strike, that option is now an ATM strike which has a much higher time value component than ITM or OTM strikes. Now theta may have eroded, the time value depending on where we are in the contract but avoiding a loss is not guaranteed….no free lunches unfortunately for us but happily for those taking the other side of our trades.

      Alan

  8. Alan Ellman May 5, 2014 5:45 pm #

    Running list stocks in the news: TRN:

    Trinity Industries, ranked #5 on this week’s IBD 50, and a stock in “bold” on our Premium Watch List, just announced a 2-for-1 stock split and an increase of 33% in its quarterly dividend. The split is effective as of June 19th. This will double the number of shares owned, the number of contracts sold and halve the srtike prices originally sold for the June contracts and halve the market share price.

    See pages 323 – 330 in the “Complete Encyclopedia for Covered Call Writing” to review how stock splits impact our covered call positions.

    Below is the current chart of TRN using the technical parameters of the BCI methodology. CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO THIS BLOG.

    Alan

  9. Adrian May 7, 2014 4:41 am #

    Alan, I have recently been studying some stocks charts against the market, to try determine whether I should have sold any stock I papertrade at the appropriate time.
    The problem I have is I’m not quite sure whether the way you are analysing these charts together confirms what I suspect would be right. So my 1st two extended questions of five are about my price performance issue:-
    1. When comparing the S&P500 price performance to a stock, then are you comparing the trendline and price pattern breaks,etc of each, to see if the stock breaks the support or resistance lines first?(so then you will know the stock is starting to become weaker than the market)?,- should I use the “close prices” of my share just as like the S&P500 is?

    2. And when you do need to compare the S&P500 chart to the shares chart for price performance after a gapdown, then over how many months should this chart be for?, – how many weeks/months after the gapdown is this action taken, or is it immediate?

    3. Is an analyst downgrade always to be bad for a stocks price?, – if so then should the stock then be sold if I am already in it?

    4. How long after an ER comes out should I enter a trade?(does it depend on stock volatility?)

    5. And do you still sell covered calls if there is an important economic report coming out(or FED news), or would you wait until it passes and then put on a trade?

    Some of my trades I practiced turned pretty bad, and have had negative returns for some months. So it seems like one or two bad trades has the potential to wipe all a months gains if we’re not careful,- just as well these were on paper!
    If you can give me some answers to all this, then with hope I may be able to reduce a paper-loss a little bit. Thanks

    • Alan Ellman May 8, 2014 7:42 am #

      Adrian,

      Here are your questions and my responses:

      1. When comparing the S&P500 price performance to a stock, then are you comparing the trendline and price pattern breaks,etc of each, to see if the stock breaks the support or resistance lines first?(so then you will know the stock is starting to become weaker than the market)?,- should I use the “close prices” of my share just as like the S&P500 is?

      As an example, if your share value dropped 5% in a week and the S&P is flat or up, there is a divergence and I would be bearish in my exit strategy execution. If, however, the market is also down 5%, I would be more forgiving, and less likely to close my entire position, but still buying back the option if the 20/10% guideline is met.

      2. And when you do need to compare the S&P500 chart to the shares chart for price performance after a gapdown, then over how many months should this chart be for?, – how many weeks/months after the gapdown is this action taken, or is it immediate?

      After a gap down, I always check the news for an explanation. Here is a reliable, free site for stock news information:

      http://www.finviz.com

      If the news is not egregious (a single analyst downgrade as opposed to corporate fraud) I wait for price stabilization after buying back the option. This will take a day or two or else I would close the position. From there, I sell OTM strikes based on current market value, not the original purchase price, as stock recovery takes place. If I see any significant divergence from the S&P 500 moving forward, I cut my losses and move on to another stock (see pages 272 – 277 of the complete Encyclopedia…).

      3. Is an analyst downgrade always to be bad for a stocks price?, – if so then should the stock then be sold if I am already in it?

      I put very little weight to an analyst downgrade. It may temporarily impact the price of a stock but basic share value is inherent in the price of the stock as analyzed by the institutional investors. Analysts are always disagreeing with each other, much like the experts you see on CNBC every day.

      4. How long after an ER comes out should I enter a trade? (does it depend on stock volatility?)

      Yes, once price volatility subsides (if there is any), it’s go time as long as the stock still meets our system criteria.

      5. And do you still sell covered calls if there is an important economic report coming out (or FED news), or would you wait until it passes and then put on a trade?

      Yes, absolutely. There are economic reports coming out virtually every day. If we avoided these we would never execute a trade. Looking at the weekly reports as a whole, however, is a very useful exercise and why I summarize these in my weekly blogs.

      6. Some of my trades I practiced turned pretty bad, and have had negative returns for some months. So it seems like one or two bad trades has the potential to wipe all a month’s gains if we’re not careful,- just as well these were on paper!

      Mastering exit strategy execution will mitigate losses and enhance gains. This must be a major aspect of your paper-trading program.

      Alan

  10. Adrian May 10, 2014 6:32 am #

    Thanks for all your answers above, and have all been quite informative for me, especially for the first two. One of my stocks this contract month I know I should have used the DMCP strategy for instead of doing roll-downs, so will have to keep this in mind for other months ahead. It started the other day when I had this stock drop around 5%, the market down only 0.5% and yet no stock news was even given. Sometimes news does come out only a few days later, – so in which case I am thinking that a comparison of this stocks chart performance to the market, and then a most likely sell of this stock would have been the best strategy to do here.
    Yet again if this same stock dropped only 1-2%, then I guess there should be no reason for me to want to sell it, – please tell me if you think otherwise on my thoughts above here. Thank you

    • Alan Ellman May 12, 2014 7:08 am #

      Adrian,

      I agree that a small drop in share price is no reason to sell especially when the 20/10% is not met. When a drop of 5% occurs, we will usually roll down or close the entire position depending on how the drop relates to overall market performance. If your decision was to roll down and share price continues to fall, once again you can roll down a second time or more likely, close the position and put the cash in a new position. When there is significant decline in share value the worst action to take is no action at all.

      Additional information can be gleaned by looking at a price chart and noting how the stock reacted in the past when it dipped below the 20-d and 100-d EMAs.

      Alan

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