A variation on the traditional covered call strategy is using a deep-in-the-money (ITM) long-term equity anticipation securities (LEAP) call option, sometimes known as a “leveraged covered call,” “poor man’s covered call,” “fig leaf,” or a “surrogate covered call write.” With this tactic, instead of owning the shares outright, you employ a LEAP, a long-dated option with an expiration date more than one year away.
Key Takeaways
- A covered call is a popular options strategy used to generate profits in the form of options premiums.
- To execute a covered call, an investor holding a long position in an asset sells call options on that same asset.
- It is typically used by those who intend to hold the underlying stock for a long time but do not expect a major price increase in the near term.
- For those seeking to boost covered call returns, using long-term equity anticipation securities (LEAPs) as the underlying asset can be a smart strategy.
Deep ITM means the option's strike price is significantly lower than the underlying stock's market price. This results in a high intrinsic value for the option, mirroring the behavior of the stock itself. This strategy is often more cost-effective and has a profit and loss profile similar to actual stock ownership.
Covered calls, the basis of this strategy, involve selling call options while holding an equivalent amount of the underlying stock. A call option is a contract that gives the buyer the right but not the obligation to buy a specified amount of an underlying asset at a set price within a certain amount of time. This method derives income from the premiums received for selling the options and affords some protection against stock price declines. However, some complications can arise. If the stock price surges above the call's strike price, you might have to sell the stock, thus narrowing your gains. In addition, the traditional covered call strategy requires substantial capital to purchase the stock, which poses significant downside risk if the stock price falls while reducing the number of contracts you can sell to generate income.
LEAP call options, by contrast, are efficient and could lower your risk. Let's delve deeper into how this strategy works.
Covered Calls
Covered call writing is done if you have a neutral to slightly bullish (rising) outlook and plan to hold the underlying shares for the long term. Since upside calls, when sold, are “covered” by owning the underlying stock, there is no inherent risk in selling (shorting) the calls. This strategy provides an opportunity to earn additional income from the premiums collected, which can serve as a buffer against minor price declines in the underlying asset.
Nevertheless, it’s important to remember that while the risk of selling the call is mitigated by owning the stock, this approach does not protect you against a major drop in the stock price—any cushion is limited to the premium received from the options sale.
In addition, the strategy inherently restricts your upside potential: if the stock price surges above the strike price of the call, as the covered call writer, you’ll miss any gains beyond this point since you’ll be obliged to sell the stock at the call’s strike price. As such, while covered calls can enhance returns in a neutral or moderately bullish market, they limit your potential profit in a strongly bullish market.
Traditional Covered Call Example
Suppose you own 100 shares of a stock. You might sell one call option contract (representing 100 shares) with a strike price slightly above the stock price.
For instance, if XYZ stock trades at $50, you might sell a call option expiring in one month with a strike price of $55 and receive a premium of $1.50 per share. If the stock price remains under $55, the option expires worthless, and you keep the stock and the premium.
Let's break this down a bit more to make it clearer:
- Initial position: You own 100 shares of XYZ at $50 per share, representing a $5,000 underlying position. This is the basis for your options strategy.
- Option sale: Next, we sell one call option contract with a strike price of $55 for a premium of $1.50. This step is crucial as it introduces the potential for additional income while setting the terms for a possible future stock sale.
- Obligation and risk: You're now obligated to sell the 100 shares for $55 each if the call option is exercised. This is a key element in the strategy.
- Adjusted cost basis: You have reduced your cost basis on the shares to $48.50 per share, making the break-even point to the downside $48.50 per share. This is a crucial calculation, so you know your potential loss or gain.
- Profit and loss scenarios: Finally, let's look at the potential outcomes. If the stock falls to zero (e.g., in the event of a bankruptcy), the maximum loss would be $4,850. Conversely, the maximum profit is capped at a $5 increase per share (from $50 to the $55 strike price) plus the $150 premium received, totaling $650. This is the range of what's possible in this scenario.
Using LEAPs in a Covered Call
Using LEAP call options instead of the stock itself is an alternative way to structure covered calls that has some key advantages. LEAP call options are basically long-term call option contracts with expirations beyond one year. These give the buyer the right, but not the obligation, to purchase the underlying stock at a specified strike price until the expiration date.
Rather than purchasing 100 shares of the stock outright, you can buy a single deep ITM LEAP call option contract controlling 100 shares. The delta of these options is high (i.e., approaching 1.00), a mathematical signal that means they will move closely with the stock price, but they require less of a commitment of your money than purchasing the stock outright.
At this point, you employ the LEAP call contract to provide the “covering” position, not the shares themselves. You can sell short-term call options against the LEAP and collect premiums just like a standard covered call. If the short call is assigned (meaning the option's buyer decides to buy the stock at the agreed strike price), you simply exercise your LEAP (use your right to buy the stock at the predetermined price) to obtain 100 shares of the stock at the LEAP's lower strike price. Then, you deliver those shares to the holder of the short-call option contract. This fulfills your obligation at the higher short-call strike price.
The LEAP call option swaps the large cost of buying 100 shares for the smaller upfront premium cost. This significantly reduces how much money you have to come up with at first. The LEAP also caps the maximum loss if the stock declines. The premium paid for the LEAP is the highest downside. Using LEAPs instead of stock is an efficient and lower-risk method for a covered call strategy. The capital outlay is significantly less, while the income generation and upside exposure are similar.
Example of LEAPs in a Covered Call
Suppose you purchase a deep ITM LEAP call option instead of shares. This LEAP acts as a substitute for the shares and has a delta close to one, meaning it will move almost dollar for dollar with the stock but at a fraction of the cost. To get the delta of your LEAP call option, you check the options chain available on most financial or trading platforms. The options chain lists all available option contracts for a particular stock, including strike prices, expiration dates, premiums, and Greeks (among which you'll find delta listed). You then sell a shorter-term upside call option against this position. Let's walk through this:
- Purchase the LEAP call option: Commencing with the strategy, you refrain from buying shares and instead purchase an 18-month LEAP call option on XYZ with a strike price of $30; you pay $21.00 for each of the 100 shares when XYZ is trading at $50. This investment totals $2,100 and mirrors owning the stock for less money upfront.
- Sell a short-term call: You then sell a shorter-term call option with a strike price of $55, collecting a premium of $1.50 per share or $150.
Here are the potential outcomes and financial implications:
- Exercise scenario: If the short-call option is exercised, you can take care of this efficiently by exercising the LEAP option. This allows you to acquire shares at $30 each and sell them at $55, fulfilling the obligation of the short call.
- Impact on the cost basis: The premium received from the short call option changes the cost basis in the LEAP to $19.50 per share equivalent.
- The break-even value: This sets a new break-even point for the LEAP, $19.50. Calculating the precise point at which you would start incurring a loss depends on the LEAP's remaining time value, its sensitivity measures like delta and gamma, and the underlying stock's volatility.
- Maximum Loss: This is capped at the total cost of the LEAP, $1,950 (what you paid minus the premium). This is your worst-case scenario.
- Maximum profit: Your maximum potential profit is calculated by taking the difference between the strike prices ($25 per share), adding the premium received ($150), and subtracting the cost of the LEAP ($2,100). The result is a maximum potential profit of $550.
Risk Reduction
Using LEAPs in a covered call strategy can reduce your risk in several ways. By opting for a deep ITM LEAP option, you can simulate the experience of stock ownership while putting in less capital. This means less of your money is at risk compared with buying the stock should its price collapse.
This scenario highlights the leverage that options offer. A deep ITM LEAP will have a high delta, moving almost dollar for dollar with the stock price. In any event, because the LEAP is bought for less than the price of the stock, the percentage loss relative to the invested capital will be lower if the stock price declines as long as the stock price remains above the LEAP's strike price.
Crucially, since the LEAP has a longer time frame before it expires, you also have more time to manage the position and respond to changes in the market or the underlying stock. This can include rolling the position to different strikes or expirations, if necessary, which can mitigate losses.
You won't eliminate all the risk, particularly as the expiration date approaches and if the stock price moves significantly. But using the LEAP is a strategic alternative to the traditional covered call that might suit those seeking less exposure to stock price declines. What you gain in lowered exposure should be balanced against the fact that you still face the potential for losses, especially if the stock price falls below the break-even point, which is the strike price of the LEAP minus the premium received for selling the calls.
| Traditional Covered Call vs. LEAP Covered Call | ||
|---|---|---|
| Feature | Traditional Covered Call | Deep ITM LEAP Covered Call |
| Capital Required | Full price for 100 shares | Cost of one LEAP option |
| Upside Potential | Capped at strike price | Capped at the difference between the LEAP strike and the short-call strike |
| Downside Protection | Only the premium received | The intrinsic value of the LEAP plus the premium received |
| Risk of Assignment | Higher if the stock price is near the strike price at expiration | Lower, as the investor has control over exercising the LEAP |
An Additional Benefit of Using LEAPs in Covered Calls
Besides its ability to reduce your risk and so on, a LEAP covered call allows you to benefit from increases in volatility. LEAPs are more sensitive to volatility changes than nearer-term options because of their higher vega, which measures how much an option's price changes with volatility. Again, you can find this and the other Greeks on most financial or trading sites. If market volatility increases, so does the extrinsic value or the time value of the LEAP—frequently more than the covered call sold. This can increase the overall value of a long-held LEAP option. In our scenario, for example, it could go from $21.00 to $22.00, which would net you a profit.
When stock prices fall, volatility tends to rise, and this inverse relationship can be an advantage for the LEAP covered call strategy. Therefore, if the stock has a downturn, the LEAP's value may not diminish as quickly as the stock itself; it may even appreciate if the volatility spike is sharp enough.
LEAP Covered Call Pros & Cons
Pros
Lower capital outlay
Downside risk reduction
Potential volatility benefit
Cons
Lower liquidity
LEAPs expire, stocks do not
Forfeit potential dividends
Must understand options more comprehensively
Risks of Using LEAPs in Covered Calls
While there are some clear benefits to using LEAPs in covered call strategies, there are risks. First, not all stocks with listed options will have LEAPs available. And if they are available, LEAPs often have less liquidity and wider bid-ask spreads than the underlying shares. This will increase your transaction costs when entering and exiting your positions.
The LEAP could expire worthless. Unlike stocks, which do not have an expiration date and may recover over time, LEAPs can lose all value if the stock price is below the strike price at expiration. This makes the initial investment in the LEAP vulnerable to a total loss, an improbable risk when holding the stock itself.
Holding a LEAP instead of the stock also means you forfeit dividend payments, which can be a considerable source of returns, especially in dividend-rich sectors. This is another of the downsides to weigh in this strategy.
How Does the Expiration Date of a LEAP Affect a Leveraged Covered Call Strategy?
The expiration date of a LEAP is critical in a leveraged covered call strategy because it offers more time for the stock to move in a favorable direction, allowing several cycles of short-term call selling against it. The longer the LEAP is, the higher its cost, all else being equal. Nonetheless, as the LEAP's expiration date gets closer, its time value decreases more rapidly, which could reduce the protective buffer it affords. The key is to monitor the LEAP's value as time passes and be prepared to adjust your strategy before the expiration date greatly affects the position.
Are LEAPs More Expensive than Short-Term Options?
Yes, all else being equal, LEAPS are typically more costly because of the longer time value, which means selling them can offer a larger premium.
Can I Sell a LEAP as the Upside Covered Call?
Yes, you can sell a LEAP option as the upside covered call in your strategy. This involves selling a longer-term call option at a higher strike price while owning the underlying stock or a lower-strike LEAP option. Selling a LEAP as the upside cover call could permit a higher premium upfront but also commits you to the position for a longer period, with the potential for higher upside if the stock goes up over that time. This approach also exposes you to the risks associated with long-term obligations, such as changes in market conditions or the fortunes of the underlying stock. It also caps your upside potential to the sold call's strike price for a long time.
The Bottom Line
Using deep ITM LEAPS for covered calls is a sophisticated strategy that can offer similar benefits to traditional covered calls while potentially requiring less capital. It enables you to participate in the upside potential of a stock while reducing your initial investment, though the risks and complexities of managing two option positions must be thoroughly understood before venturing forward with a LEAP-based strategy.
Article Sources
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