On Tuesday and Wednesday, the market went through the roof. Not a problem, because we weren't standing on the roof. We're safely in the basement. Our cushion for the SPX bull put spread is back to about 150 points. The cushion for the RUT bull put spread is about 76 points. Those are good sleeping cushions.
Today, the market surprisingly held Tuesday and Wednesday's gains. After two substantially up days, it's reasonable to expect that we'll give back a chunk. After hours, DELL disappointed and is trading down more than $2.50. That should bring things down a bit. We'll see if the market has the strength to work its way through some bad news and continue its move back up. As it stands now, the market still appears to be in a downtrend.
I just heard a talking head say the chance of a December rate cut is 100% for 25 basis points - and 60% for a 50-point rate cut. How they figure this stuff out I'll never know. I think the same guys that screw around with our Friday morning settlements are the ones who come up with these arbitrary percentages. But, the TV audience and the markets seem to buy into it, no questions asked.
A Common Question Of Interest
Answer: The above example is a version of a covered call strategy - except, instead of owning a stock, you own the LESP. It's also considered a diagonal calendar spread. You can substitute a LEAPS call purchase for the purchase of the actual shares of the underlying stock. It's a little trickier than owning the shares of stock. You have to pay closer attention to the position. Remember, covered calls are appropriate for investors who are neutral to mildly bullish on the underlying equity.
First, let's take a closer look at your example. Some of the numbers are off. The January 2009 $30 call on ABC will cost a lot more than $22. An in-the-money option has both intrinsic and time values. The intrinsic value is the amount that the option is in the money, and the time value is derived by subtracting the intrinsic value from the current premium. In your example, the January 2009 30 call would have an intrinsic value of 25 (ABC stock price of 55 minus the strike price of the call). Because it's a LEAPS, it would also have substantial time value. So, let's adjust the purchase price of the LEAPS call in your example to 35, which gives the option a time value of 10 (price of option minus intrinsic value). By the same token, out-of-the-money options have only time value. Since the October 60 has only one month left until expiration, a premium of $5.50 is too high. It's more likely that you receive a premium of about $2.
The revised example now involves stock ABC, which is trading at 55. The January 2009 30 call is purchased for 35, and the December 60 call is sold for 2, which results in a net cost of $3,300 ($3,500 purchase cost of LEAPS less $200 received for the sale of the call).
If ABC rallies and closes above 60 at expiration, in all likelihood you will be assigned the shares. This is where the quasi-covered call differs significantly from the covered call. In a covered call strategy, you would simply hand over the shares that you already own. With your strategy, you have choices -- you can exercise the LEAPS and acquire the shares at less than half of the current market price, or you can sell the LEAPS, which will have appreciated nicely, and use the proceeds for the purchase of the stock in the open market.
Typically, you'll be better off selling the LEAPS because you will capture both the intrinsic and time values of the option. For example, let's assume ABC rallied and closed at 64 at December expiration. You could exercise the LEAPS call, which will result in a $3,400 discount on the current market price of ABC. However, the January 2009 30 call could be worth around 43.50 at December expiration. You could sell the call and use the $4,350 to offset the cost of acquiring XYZ.
Another choice, and perhaps the best one, requires you to monitor your position and take action when necessary. This is the major difference between the LEAPS strategy vs. the stock owning scenario. You need to pay close attention to the deltas of both the LEAPS and the sold December call. As long as the delta of the LEAPS is higher than the delta of the short call, you're just fine. However, once the delta of the December call begins to exceed the delta of the LEAPS, you are losing money. It's time to buy back the short December call. You then have a few more choices. You can roll out your short call to a higher strike price in a later month, or you can simply sell the LEAPS and sit back and count your profits. It all depends on your outlook for ABC, your risk tolerance, and your investment objectives.
If ABC falls and closes significantly below 50 at December expiration, your action will depend on your outlook for the stock. If you think ABC still has some downside, you may decide to sell back the LEAPS and close the position entirely. The loss you take on the LEAPS position will be slightly offset by the $200 premium you received for the sale of the December 60 call.
If you think ABC will rally substantially over the next year or so, you may want to hold on to the LEAPS in order to have exposure to that potential upside. You can even choose to write another call against the January 2009 30 call in order to collect additional premium to further offset your losses on the LEAPS position. In fact, if you wrote a covered call at 2 every month until January 2009, you could conceivably collect a total of $1,600 if all the options expired worthless. This would defray a large percent of the original cost of the LEAPS.
Those of you who have been reading me for awhile, know I'm not a fan of covered calls. They're dangerous, unless you turn the position into a Collar. Calendar spreads can work out nicely - IF you monitor the position and know when to GTFO.
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