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Educational Article

Covered Calls and Calendar Spreads

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By Lee Lowell

These are topics that seem to get lots of press on many financial websites, including OIN. I'd also like to write about these strategies not only because they are very popular to many investors, but because I too am starting to increase my use of these tactics.

Covered calls are considered to be one of the most conservative and safest of all option strategies. This is why brokerages will allow almost anyone who fills out an option agreement to employ this strategy. There really is no extra risk in selling a covered call that a brokerage needs to worry about. The investor already has the shares in the account, so he/she is covered against the short call. And since the investor already faces the risk of their stock going to zero, the covered call will actually offset that catastrophe by a few points. The only downside to this strategy is that the investor may have their profits capped if the stock starts to blast off.

If you read my article from 08/07, you'd see that I expanded on the use of covered calls to give yourself some downside protection and a possible monthly inflow. Everyone should employ these tactics. You need to get the most out of your portfolio by utilizing option strategies that work with what you already have. Don't just "wait and hope" for your languishing stock to go back up. Sell a call against it. This at least keeps you involved and may help to increase your returns. For years, I sat with my portfolio of stocks knowing that eventually over time they would all go up. But for those periods of meandering and downticks, I would just chalk it up to "that's the market." I now know that a majority of stock and indices, in general, trade within certain ranges and patterns, which makes me more comfortable selling covered calls. I can lower my cost basis by a few points during those down periods and by using the tools of the trade, I can pick the most effective calls to sell. If my stock moves up, then hopefully from my analysis the call that I sold will still expire worthless.

I think the reason that most people are hesitant to sell covered calls is due to the possibility of losing their stock, and missing out on a big upside move. But, how many of you were wishing back in March and April that you had some covered calls that could've saved you lots of money during the correction? You can never time the market, so you can never know when a good time might be to sell a call. That's why you should always look to sell calls against your longs every month. Now you may have a good feeling about the stock or it might be in a good uptrend right now. That's fine. If you feel really good about the near-term, then hold off from selling the call. If you are worried about being called out and possibly missing out on the "big move", then you can always buy the call back for a small loss. Or you can buy the call back and roll it out to the next month's option. Just remember, if you are losing money on the short call, you are guaranteed to be making MORE MONEY on your long stock. That's how covered calls work. I can hear it now, "why take the chance of losing any money by buying back the short call for a loss if I know my stock will eventually go back up?" The key word is "eventually." Like I said, what about those in between times when there's no movement and those times of slow downward drifts? Do you want to bring in a few extra dollars each month or do nothing? This doesn't have to be a long-term commitment. You can sell front month options each month that decay very rapidly. It's up to you. I know what I'm going to do.

I want to talk about a variation of the covered call. It's a cross between a covered call and a calendar spread. The strategy involves buying an in-the-money LEAP call option and selling a closer-to-expiration call option with different strike prices. In a traditional calendar spread, a longer-term option is purchased and a near-term option is sold, with both options having the same strike price and both being calls or puts. Additionally, if the near-term option has higher implied volatility than the longer- term option, than you will have an even better edge in the trade.

With the new strategy, you will purchase an in-the-money LEAP call and sell a closer-to expiration call whose strike price is dependent on the premium of the LEAP. In a covered call strategy, you either already own the stock and then sell a call against it, or you can be the speculator and simultaneously buy the stock and sell the call at the same time. Buying an in-the-money LEAP call will not only closely mimic the movement of the long stock (delta effect), but it will cost less to do so. This will also lower your total loss should a potential downside disaster occur. Buying the LEAP also gives you plenty of time for the strategy to work and keeps the decay to a minimum (theta effect). You should buy at least the 2002 or 2003 LEAPs. So in effect, you really are implementing a covered call strategy except that the LEAP is a surrogate for the stock. And since we are dealing with options in different months, we are also in theory conducting a calendar spread.

The LEAP call should be about 20 points in-the-money which will probably have at least an .90 delta. The short call against the LEAP has to be at a strike price that comprises the strike of the LEAP plus its premium. Here's an example. I've been considering buying LEAP calls on Nokia which is trading around $46. I've decided that I want to purchase the Jan '02 $25 calls for a premium of $24 or lower. If I get filled, I want to start selling calls with a strike price of $49 or higher ($25 call + $24 premium = $49). In this case, I would look to sell a Nokia $50 or higher call in a month that has a few points of premium. This could either be the Oct 2000 or the Jan 2001 calls. The reason why you want to sell a call with that specific strike formula is because it eliminates the negative effect of being called out of a LEAP call prematurely. The one problem of a regular calendar spread in which both options are of the same strike price is that if the stock sky rockets and you are called out of the near-term call, you may be forced to exercise the long-term call. This basically makes you forfeit all the time premium you just paid for. With the in-the-money LEAP call, this is not a factor because of the little time value it has to begin with. Once the stock starts to sky rocket and you are called out of the short call, your LEAP will practically consist of all intrinsic value, so early exercise is not an issue. It's the same as if you had to give up your shares of stock.

Remember, an ITM call with a delta of .90 is comprised almost entirely of intrinsic value so you don't have to worry much about time decay or exercising prematurely. I can either buy 100 shares of NOK for $4600 or spend $2400 for the Jan '2002 $25 call and get almost the same results. I have 1.5 years for the trades to work for me. Right now, the Jan '02 $25 call is trading for $24 with NOK trading at $46. That means it has $21 worth of intrinsic and $3 worth of time premium (very small). Let's say I sell the Jan '01 $50 calls against it for $4.50 and NOK finishes at $55 on expiration day in Jan '01. I will be called out of my Jan '01 $50 calls for a 1/2 point loss ($5 point intrinsic - $4.50 initial premium intake) and I will have to exercise my Jan '02 $25 calls to cover it. The $25 calls at Jan '01 expiration are worth $30 intrinsically, but they are trading for roughly $30.75 in the marketplace (using an options calculator). This means that I will only be giving up 3/4 point in lost time premium due to the early exercise. I can live with that. Also, my overall gain from the LEAP/short call is +5 1/2 points. If I had instead purchased 100 shares of NOK with the short call, my gain at Jan '01 expiration would be +8 1/2 points. I'd make an extra $350 if I owned the stock but it would've cost me an extra $2200 to make the trade initially. I think I'll stick with the LEAPs.

The strategy is worth a look if you have some LEAP calls that interest you. I welcome all questions.

Good luck.

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