Although not a true covered call write, purchasing LEAPS and selling a call option on that position is an alternate strategy that has its pros and cons, says Alan Ellman of TheBlueCollarInvestor.com.
Covered call writing entails buying a stock and then selling an option. But what if I buy a call option instead of the stock and then sell a call option on that option? I’ll be spending less money than the outright purchase of the equity and still generate cash from the sale of the call option! This idea has come to many of you, and as a result of your inquiries, this article had to be written. Although not a true covered call write, purchasing a long-term option (more than one year out), called LEAPS, and then selling call options against that position, is an alternate strategy similar to CC writing. Technically, these trades are known as calendar spreads, so perhaps we should start off with some definitions: 
LEAPS - Long-Term Equity Anticipation Securities. These are option contracts with expiration dates longer than one year. Not all stocks and ETFs have these type of options associated with them.
Calendar Spread - Simultaneously establishing long and short options positions on the same underlying stock with different expiration dates. For example, you buy the December 2010 $20 call and sell the April 2010 $20 call on the same equity.
Horizontal Spread - A spread where both options have the same strike price as in the above example but different expiration dates. The terms calendar and horizontal spreads are interchangeable.
Diagonal Spread - A long and short options position with different expirations AND strikes. For example, you buy the December 2010 $20 call and sell the April 2010 $25 call.
Concept Behind This Strategy
The investor establishes the long option position by purchasing (usually) I-T-M LEAPS and then selling a near-term, slightly O-T-M call, the short position. Trades are constructed such that, if assigned, the difference between the spread ($5 in the above case where the $20 call was bought and the $25 call was sold) + the short premium collected, exceeds the cost of the long option. If unassigned, where the price of the stock does not exceed the strike price of the short call, we then continue to write calls and generate a monthly cash flow. The problem in this second scenario is that if the stock price falls, the premiums generated from the short call drops unless we write for a lower strike, which may result in a loss for this long-term strategy as the spread (difference between the two strikes) declines.
Let’s take a look at the options chain for a highly traded equity, INTC:
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INTC currently priced @ $20.43
With the stock priced @ $20.43 let’s look for a deep I-T-M LEAPS:
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LEAPS for Covered Call Writing
NEXT PAGE: Pros & Cons of LEAPS
|pagebreak|INTC - Deep I-T-M Calls
The January 2012 $10 strike is purchased for $10.60, $10.43 of which is intrinsic value and only $0.17 is time value. Minimal time value is a characteristic of deep I-T-M LEAPS options.
Next let’s check the near-term, slightly O-T-M strikes:
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INTC - Near-Term, O-T-M Options
The next month, $21, slightly O-T-M strike can be sold for $0.43.
Let’s do the math, if assigned:
We collect the difference in the spread ($21 – $10 = $11) + the short option premium = $0.43 for a total of $11.43. We deduct the cost of the long call ($10.60) for a profit of $0.83 per share or $83 per contract. The percentage return is $83/$1060 or 7.8%. All calendar spreads are constructed such that there is a profit, if assigned.
If the shares are not assigned (price of stock NOT greater than the strike of the short call ($21), our profit is $43/$1060 = 4.1% and we’re free to sell another option. As noted above, this works well as long as the share price does not dramatically decline thereby reducing the returns on the short options. We also must bear in mind that the long call (LEAPS) is a decaying asset and there will become a time when we no longer own the right to purchase INTC at the $10 strike (when the option period expires). If we continue to generate monthly returns of $43, how long will it take us to retrieve the $1060, if never assigned? Here’s the math:
$1060/$43 = 24 months, not counting any difference in the spread.
Our option is good for about 22 months, so if the option ultimately expires worthless and the spread has decreased, we lose! Diagonal spreads work best for rising stocks where we can take advantage of the difference in the original strike prices.
Advantages of Using LEAPS
- Less costly than purchasing stock; remaining cash can be used to generate additional cash
- A declining stock will have time to recover
- Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.
Disadvantages of Using LEAPS
- 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 approval will be required by most brokerages to allow this type of trading
- The long calls will ultimately expire, stocks will not
- Forced assignment may not allow for a profitable trade
Conclusion
Purchasing LEAPS and selling a call option on that position is NOT a true covered call write. It is an alternate strategy that has its pros and cons. For most Blue Collar Investors, covered call writing is the better path to take. But to some investors who fully understand the nuances of diagonal spreads, this may be a viable alternative.
By Alan Ellman of TheBlueCollarInvestor.com
