LEAPS are long-term options with expirations usually greater than 1 year.
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
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.
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.
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.
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,
My best to all,