Wednesday, February 24, 2010

LEAPS Covered Write - Part I

I've been known to take a few leaps in my day (and I've been told to take a few as well), but one that I really like to take is the LEAPS Covered Write.  This Option Strategy is one that embraces the warm fuzzy feeling of a Covered Call, yet allows the trader to leverage and still retain some safety in the trade.  This is a Calendar or Diagonal Spread Trade that enables the trader to have monthly income while lowering the amount of capital required upfront.

With some Covered Call traders, the number one problem they face is being able to buy enough Stock to make the trade worthwhile.  With the LCW the underlying is the LEAPS and the cost is a fraction of what the trader would normally have to pay for the Stock.

The LEAPS Covered Write is assembled by purchasing a LEAPS that is deep in-the-money (ITM) and that has a high Delta (preferably .90 or better) and then selling the short-term Call Option which is out-of-the-money (OTM). 

Let's take a look at one of the most widely traded products in the market - an ETF named the SPY.

 

The LCW requires that you have a flat or moderately bullish underlying.  The SPY is trading at $110.82.  For many a Covered Call trade would be too expensive and the return on the trade is minimal (about 1.5%).   Instead of having to buy the SPY, we look to the LEAPS to be the substitute.  In checking for the proper LEAPS the trader normally selects the first expiration month available and a deep in-the-money strike.  The Dec 90 LEAPS are chosen.  For Index or ETF underlying products, the LEAPS may or may not be in January.  In this case the 90 LEAPS Calls have a 0.9027 Delta and a cost of $22.36.  The LEAPS are purchased and then the short-term Call (the March $111.00) is sold (the same Call Option if the trader was doing a regular Covered Call).  Instead of a 1.5% return, the structure of this trade returns 7.7%  ($1.74 / $22.36).  By structuring this trade, we've essentially increased our return by about 7x!

Next post, we will explore managing this trade and a proper exit strategy.

2 comments:

  1. With regards to assignment, what are the risks associated with that, or are there any being ITM?

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  2. This is now answered in LEAPS Covered Write - Part II

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