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Covered Calls on the Cheap

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By Mark Phillips

In a bull market like we have seen up until early last year, it seemed like you could just buy Call options and watch your account grow month after month. In case you haven't noticed, the market has changed significantly and if you are still playing by the old rules, it is unlikely that you will be playing for very long.

The recent oscillations in the market are enough to make even the most seasoned trader seasick, but once you recognize the new pattern that has developed, you can adjust your trading strategy to take advantage of it. It really doesn't matter if you are looking at NASDAQ stocks or NYSE stocks, there are a lot of equities that have spent the past 2 months trading sideways.

A safer way to profitably trade options in a turbulent market like we have now is to extend the time horizon from short-term to long-term. Buying more time costs more up front, but allows you more time to be right. Designed for option traders wanting a longer time frame, LEAPS provide the ability to take advantage of the great entry points provided by this turbulent market, while avoiding the rapid time decay of short term options. Of course, if the market is heading south in a hurry, it doesn't matter how much time you buy, you are still going to get burned.

We need a market with most of the downside removed before we start contemplating new long-term long positions. With the Fed on our side, it seems clear that the downside in this market is limited, and the only big question is when economic conditions will improve. While we are waiting for those conditions to arrive, we can generate consistent cash flow using the tried and true (although sometimes dull) strategy of Covered Calls

The term "Covered Call" normally refers to writing calls against a long stock position, but since a LEAP can be used as a substitute for the stock, the term "Covered Call" is still appropriate. The big difference between writing Covered Calls against stock vs. LEAPS is that with LEAPS you do not want to have the short-term option exercised. In other words, you don't want to get called out of the LEAP you just bought. This would result in having to liquidate your long LEAP position, and you would throw away all the extra time value acquired by purchasing the LEAP. There are several different Covered Calls approaches that can be employed, but the one we will cover here (and my personal favorite) involves writing front month calls against the LEAP with the goal of having them expire worthless.

The first part of the strategy involves purchasing the LEAP at a good entry point (sounds easy, huh?). Although LEAPS give you the ability to profit without having the perfect entry point, exercising the discipline necessary to achieve a good entry point will obviously improve the profitability of the position. Simply put, we want to purchase the LEAP when the stock bounces from a major support level. It helps immensely if the daily (and ideally, the weekly) Stochastics oscillator is making a northward move out of oversold territory. And just to add a little extra insurance, let's make sure the sector in which our chosen equity operates is on a similar recovery path. Once the LEAP has been purchased, we need to wait for the stock to appreciate before writing our short-term call against the LEAP.

Covered Calls on LEAPS is the type of strategy that I prefer to leg into - specifically, the front month call is sold against the LEAP when the underlying stock moves up to resistance and rolls over. Since you want the call that you sell to expire worthless, you want to sell a strike above the resistance level that you think will hold.

The big advantage to using LEAPS as opposed to buying shares when choosing to trade a Covered Call strategy is cost, and consequently Return on Investment or ROI. When trading covered calls, we have to either own 100 shares of the underlying stock or a LEAP before we can write the short-term calls. If we assume a $50 stock, it will cost us $5000 just to establish the long side of the position. But if we opt for LEAPS, we can establish the same position (with 18-24 months to be right) for as little as $1000-1500. The premium we receive for the short-term call will be the same in either case. Spending only 20-30% as much for the LEAP as the underlying shares gives us a much higher ROI for the same move in the stock.

Let's look at a hypothetical example and bring it all into focus. Assume we purchase 100 shares of stock JKLM for $50 per share for a total cost of $5000. Have you noticed that almost all hypothetical examples use stock XYZ? I thought I'd be a little different. Then we wait for a rise in the stock, and since we were careful about our entry point, over the next 2 weeks, the stock gradually rises to $62 per share. As it begins to run out of steam, we decide to sell the JUL-65 Call (just above major resistance) for $3. Just like clockwork, the stock begins to decline and on expiration Friday is resting at $56.

So let's check our ROI on the position. The stock has appreciated by $6 and we get to keep the $3 premium from the expired call that we sold for a total gain of $9. Divide 9 by 50 for percentage return and we get an ROI of 18%. Not bad for a month's work, but let's see what happens with the LEAP. Let's assume we bought the JAN-03 $50 LEAP for $12.00, for a total cost of $1200. With the same stock movement, we would likely see an appreciation of $3 in the LEAP by July expiration, and would still get to pocket the $3 from the expired short-term call. Sure, we only gain a total of $6 on the position, but let's do the math and I think you'll see the light. Divide 6 by 12 and we get an ROI of 50%. I don't know about you, but I like those numbers a whole lot better.

Ok, I know you are wholly unimpressed with my hypothetical example and want to see real numbers from real trades. Your wish is my command, but I'm out of space for tonight. Tune in next time, and I'll cover a couple of real-world examples, and you can see that the numbers really do add up. As an added bonus, we'll cover what to do when a LEAPS covered Call position goes bad.

Until next time.

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