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Using LEAPS in A Covered Call Write

This document discusses using LEAPS (long-term equity anticipation securities) in a covered call strategy to generate income from option premiums while reducing downside risk. It describes how purchasing a deep in-the-money LEAP call option and writing covered calls against that position requires less capital than a traditional covered call strategy, while providing similar upside profit potential but significantly less downside risk if the underlying stock price declines. The strategy works best in a low volatility environment since LEAPS are sensitive to volatility changes, and the long LEAP position would benefit from any volatility increases over the multi-year time frame before expiration.

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Jonhmark Aniñon
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268 views

Using LEAPS in A Covered Call Write

This document discusses using LEAPS (long-term equity anticipation securities) in a covered call strategy to generate income from option premiums while reducing downside risk. It describes how purchasing a deep in-the-money LEAP call option and writing covered calls against that position requires less capital than a traditional covered call strategy, while providing similar upside profit potential but significantly less downside risk if the underlying stock price declines. The strategy works best in a low volatility environment since LEAPS are sensitive to volatility changes, and the long LEAP position would benefit from any volatility increases over the multi-year time frame before expiration.

Uploaded by

Jonhmark Aniñon
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Using LEAPS in a Covered Call Write

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By 
JOHN SUMMA
 
 
Updated May 6, 2021
Covered call writing is generally thought of as a conservative option writing
approach because the call options that are sold for the premium are not naked.
Covered call writing involves owning the underlying - which may be stock
or futures contracts - and selling the call options against that underlying position.

Should the covered call option get in the money (ITM) with a rise of the
underlying, the worst that can occur is that the stock position gets called away. In
such a scenario, the investor still gains because the premium is retained as profit
while the stock position rises to the strike price of the covered call option, the
point at which the writer would be assigned during an exercise.

KEY TAKEAWAYS

 A covered call is a popular options strategy used to generate income in the


form of options premiums.
 To execute a covered call, an investor holding a long position in an asset
then writes (sells) call options on that same asset.
 It is often employed by those who intend to hold the underlying stock for a
long time but do not expect an appreciable price increase in the near term.
 For those seeking to boost covered call returns, using a LEAP option as
the underlying may be a smart strategy.
Covered Calls
Covered call writing is typically done if the investor maintains a neutral
to bullish outlook and plans to hold the underlying long-term. Since the calls sold
are "covered" through ownership of the underlying, there is no upside risk in
selling (shorting) calls. However, the problem arises on the downside, where a
large unexpected drop of the underlying can result in large losses, as the call
premium collected in a typical covered call write affords an investor very limited
protection.
Since stocks can drop quite far quite quickly, the small amount of call premium
collected in most covered-call writes is very little for hedging downside risk.
Fortunately, there is an alternative if you want to reduce downside risk but still
collect call premium with covered writes and have upside profit potential.

One covered call approach that offers the potential for improved overall
performance, known as the "surrogate covered call write", uses stock
option LEAPS instead of stock as the underlying asset.

Example: The Traditional Covered Call Write


To demonstrate this surrogate strategy, first consider a traditional covered call
hypothetically written on J.P. Morgan (JPM) shares. Assume that JPM stock is
trading 35.72. If an investor were mildly bullish on JPM, they could apply a
traditional covered call, which has some modest room to profit from more upside.

If the investor wanted to hold a six-month covered call, they could sell the slightly
out of the money 37.50 call, which is trading at $1.60 If JPM closed at expiration
just at the strike price of the 37.50 call (the maximum profit point), there would be
a profit of $1.78 per share plus the entire $1.60 profit for the call option that was
sold but which would have expired worthless. The maximum profit is thus $3.38
per share. There could also be an additional small gain from any dividends
earned during this six-month period, which is not factored into this case.

Traditional Covered Call Write


July Call Call
JPM Price Strike Premium Maximum Profit
35.72 37.50 $1.60 $3.38
Substituting a LEAP Option
For the surrogate approach, instead of buying JPM shares, the investor could
purchase a deep-in-the-money LEAP call option with a strike price of 25 expiring
in twenty-four months, which for our example is trading at $10.70. In other words,
instead of owning J.P. Morgan shares, a two-year call option LEAP acts as a
"surrogate" for owning the actual underlying.

Ideally, this strategy works in a mature bullish market, which is usually


accompanied by low implied volatility. We want a low volatility environment
because LEAPs have a high vega, or a larger price sensitivity to changes in
volatility. LEAPs, otherwise, have the same basic pricing fundamentals and
specifications as regular options on stocks.
The LEAP premium represents intrinsic value only (i.e. very little time value)
because the option is so deep in the money. Since there is little time value on
this option, it will carry a delta close to 1.00. Owning the LEAP thus acts as a
surrogate to owning the actual shares, but ties up considerably less capital.

The LEAP owner can now sell the same JPM 37.5 call for $1.60 against this
LEAP. If JPM closes at $37.5, the maximum profit of $3.38 would be reached,
the same maximum profit of the previous example but requiring less upfront
capital. Therefore, there is a greater return on capital employed (ROCE).

LEAP-Based Covered Call Write


July 37.50 Call
Jan 2006 25 LEAP Price Price Call Premium Maximum Profit
10.70 1.60 $1.60 $3.38
The LEAP ties up just $1,070 (10.70 x 100 shares in a call contract), which is
around one-third less than the $3,572 required in the traditional covered call. If
one could establish a long position in the underlying for less than one-third the
required capital for a traditional covered call write, it would make sense to
convert to a LEAP-based strategy simply on this basis - although, dividends
would ultimately have to be factored in to create a fair comparison. However, the
downside risk story is substantially altered, which is the more important issue.

Maximum Downside-Risk Reduction


Let's say that at expiration, JPM closes at 30 instead of at the maximum profit
point assumed above. Table 3 below summarizes the losses for both covered
call positions. As you can see, the traditional covered call write loses $572 on the
stock position ([$35.72 - $30] x 100 shares = $572). This loss is offset partially by
the profit on the expired-worthless July call, leaving a net loss of $412 ($572 -
$160 = $412).

For the LEAP-covered write, meanwhile, the position would show the same loss
amount, as the delta on the LEAP closely mimics the long stock position when in
the money. Since the LEAP call has a strike price of 25, it is still well in the
money at 30. It would have, therefore, lost $412 ($572 - $160 = $412). However,
should the stock fall lower, the advantage shifts to the LEAP strategy.

For example, should the close at expiration of JPM be at 25, the loss on the
traditional write would be $1,000 larger at $1,412, but the LEAP-covered write
can lose a maximum of only $10.70 minus $160, or $910. It would also actually
show a lower loss at 25 due to the remaining time value on the LEAP, which
would be about $150.00, and the impact of volatility which we have not examined
yet. This is where it gets more interesting as an alternative strategy.
Loss comparison if JPM falls to 25
Traditional Covered Call LEAP-Based Covered Call LEAP-Based Strategy Loss w/
Write Loss Write Loss Volatility Edge
$1,412 $760 $480
Therefore, at a share price of 25 upon expiration of July 37.50 calls, if we
assume there is approximately $150 in remaining time premium on the LEAP
call, losses would be $760. That is nearly 50% less than the -$1,412 on the
traditional write (see Table 3).

Volatility Advantage
The LEAP strategy is even more attractive when we take volatility into account.
Since LEAPs have a high vega, a rise in volatility would raise levels of intrinsic
(i.e. time value) on a long LEAP position, such as the one we assume for this
article. At the time of this writing, JPM volatility was at a very low level - so low, in
fact, that it has been this low only 2% of the time during the past six years.
Therefore, the JPM volatility has a good chance of rising during the 24-month
period before the LEAP expires and even before the covered call expiration date,
helping us out on the downside.

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