What’s A Covered Call?
In a covered call, a stock holder sells call options (usually out of the money) against their underlying stocks thus generating an additional income stream.
For example, a holder of 100 shares trading at $430/share might sell a 3 month call option contract (which typically covers 100 shares) with a $450 strike price for, say, $1,000.
Should the stock be below $450 after 3 months, the trader keeps the $1,000 and still holds his/her shares.
They can then repeat the trade every 3 months, potentially earning $1,000 each time.
The risk is the investor’s 100 shares will be ‘called away’ if the stock finishes above $450. Thus any rise above $450 is forfeit.
Here’s the P&L Diagram showing the profitability of this covered call:
What is a LEAP call option?
Long-Term Equity Anticipation Securities (LEAPs) are options with a long expiry date, typically 18 months or more.
LEAP call option contracts thus give the right to buy 100 shares anytime for the next 18 months (or more with longer dated options).
They are thus extremely valuable, and therefore expensive. In the above example a $450 LEAP call might cost $50+ a share.
However, this $50 gives the owner control over 100 shares, rather than the full $450 to purchase the shares. It is therefore a potentially more capital efficient strategy.
What Is A Covered Call LEAP Write?
Covered Call LEAPs involve a combination of the above two concepts.
Instead of owning 100 shares and writing calls against them, a trader purchases a LEAP call option and sells the same 3 months calls.
Thus in our example a LEAP call option is purchased (18 months expiry, $450 strike price, $50/share, say) over which a slightly out of the money call option is sold every 3 months.
Advantages Of Covered Call LEAPs
The key advantage has been alluded to already: capital efficiency.
In the above example a LEAP call option can be purchased for $50 x 100 = $5,000 rather than $450 x 100 = $45,000 to purchase the shares outright (possibly less with margin accounts).
Thus if the investor receives $1,000 every 3 months (say) in options premium from their call, the Return On Capital is much higher.
Disadvantages Of Covered Call LEAPs
The key disadvantage is time decay. A LEAP option, particularly a close the money one, has a high intrinsic value which decays to zero over time.
In our example all the $50 option value will decay – slowly at first – to nothing over its 18 months life. Compare this to the shares: they retain their value.
There is a common way to mitigate this: buying deep in the money LEAPS where a significant portion of the option’s value is extrinsic. The intrinsic value is lower for well ITM options.
In our example it might be possible to purchase a $350 expiry date 18 month LEAP for $105, say (with the stock trading at $430), meaning the option only has $25 of intrinsic value to decay.
The trade off is in capital efficiency: we are now required to invest $105 x 100 = $10,500 rather than $5,000. But this is still significantly better than purchasing the shares ($45,000 capital requirement).
Covered call LEAPs, especially when using deep in the money LEAPs, are an excellent capital efficient strategy for the advanced trader.
This capital efficiency, however, needs to be set off an increased risk due to the existence of time decay in the intrinsic value of the LEAP calls.
Frequently Asked Questions:
What are the best stocks for the LEAPs covered call strategy?
The best stocks are those which you’d consider a good, stable investment in the long term.
A stock which rises slowly over time would be the perfect vehicle. Too much volatility would risk the short call being calls away often. Plus the probable increased implied volatility would make the LEAP expensive.
What’s the average return selling covered LEAP calls?
A good covered call return is about 1-2% a month.
Given the capital requirement is lower, the LEAP covered call strategy should beat this, but at additional risk from the factors mentioned above.