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Covered Calls on the Cheap - A Success Story

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By Mark Phillips

Last week we dove into the topic of writing Covered Calls against LEAPS as a way to mitigate risk during a sideways market. This approach has a distinct advantage over the standard Covered Calls approach, where the long leg consists of actually owning the shares of the underlying stock. Due to the greatly reduced cost basis with LEAPS, the return on investment (ROI) is much larger on a percentage basis.

After covering the basics of the strategy last week, I left you with a hypothetical example to demonstrate the validity of the strategy in broad-brush strokes. My article this evening will dissect a real-world trade, hopefully demonstrating the details of how such a strategy is implemented.

Our first task is to find a stock with a modest uptrend, or at least a nice sideways trading pattern. We want the LEAP to hold its value or appreciate slowly, while the calls we sell every month should put decaying time premium in our account. A steeply trending stock is not what the doctor ordered for this strategy.

My example is laced with a bit of vengeance, due to the fact that I hate to lose to the market, especially when I know I'm right. Long-term fans of the LEAPS column will remember when we took a position in 2002/2003 AOL-Time Warner (NYSE:AOL) LEAPS in early March, setting a stop at $35. Well, I should have given it a bit more room before cutting it loose, maybe to the $32 area. On Aril 3rd, AOL closed at $33.90, triggering our stop and booting us out of the play. The very next day the stock reversed on heavy volume and closed back over the $35 level. The LEAPS column couldn't react that fast, but I sure could. Although it was a high-risk move, due to the recent market action, I liked the bounce at a higher low and the story behind AOL, so I jumped into the $40 2003 LEAPS (VAN-AH) for $8.70 at the close, purchasing a round lot of 10 for $8700.

Now recall that I like to leg into my Covered Calls. There is more risk involved, to be sure, as the stock could head south before you've had a chance to mitigate it by selling the first month's call. But since I typically initiate my LEAPS positions when the stock is in an oversold condition, odds favor an upward move in the stock in the near future. Also, if the stock does head south in a hurry, the Covered Call really doesn't do much more than take the edge off the pain. Nothing ever takes the place of stop losses, and we have to use them judiciously, even in this strategy. I couldn't have timed it much better on AOL (I wish I could have done as well with the rest of my portfolio this spring), and literally picked the bottom. We can't count on being that lucky very often, but sometimes you have to go with your gut, especially when the technicals are in your favor.

After waiting for more than 2 weeks and clapping my hands with glee as AOL rose back towards the $50 mark, I finally saw my opportunity to take in some premium as the ascent began to slow. The $50 mark looked pretty firm, but I wanted to give myself a little bit of insurance in case the stock broke through this level, so I sold the $55 May Calls (AOO-EK) on April 27th for a whopping $0.70. Not exactly a windfall, but it did allow me to pocket $700, reducing my cost basis for the LEAPS to a round $8000. Once again, time to wait and let the market deliver the verdict as to whether I had acted wisely.

Notice that the Stochastics are pegged in overbought territory where I sold the covered calls. While this oscillator can remain there for some time to come, odds favor flat to down motion for the near future. Also, remember that we are hoping for a rangebound market, and that is the type of condition in which oscillators excel, giving buy and sell signals at relative lows and highs, respectively.

So let's fast-forward to May expiration (May 18th) and see how we did. Sure enough, the stock failed to penetrate the $55 level, but this is a clear case of saved by the bell, as the stock closed above $57 a mere two days later.

I must say I was getting a bit nervous near the end of the May expiration cycle, but my faith was rewarded as the stock closed at $54.43, allowing me to keep all the premium I took in a few weeks before. On Monday morning, the stock was still in ascent mode, prompting me to hold off on selling the June calls until some weakness emerged. All the way to the closing bell, it kept pointing up and I spent the day on the sidelines. The next day was a different story though, as AOL gapped up and quickly began falling back to earth. With all my oscillators pegged in overbought, it seemed like the time to strike. Given the break above our $55 resistance level, I decided the $60 strike made more sense, given our desire to not have our LEAP called away from us.

So in a flash, during amateur hour (when volatility is the highest), I sold 10 of the June $60 Calls (AOO-FL) for $1.00, or a total credit of $1000. This dropped the total cost basis of our LEAPS down to $7000, and a quick look at the daily Chart of AOL shows that our LEAPS were never in danger of being called away throughout the June expiration cycle.

On June 15th, the sold calls expired worthless, leaving us free to repeat the process in July when conditions dictate a favorable entry point. As of this writing, AOL has not yet provided what I think is an attractive entry point for the July cycle options. But with daily Stochastics entering overbought territory, we are getting close. All we have to do is wait for the inevitable rollover, which will begin to materialize on the hourly chart first (the reason I tend to monitor it even for my long-term trade entries), giving us another high-odds, low-risk play for the month.

Coming back to the May expiration cycle, I mentioned that we were saved by the bell. If the price spike came before May expiration, we would have had two choices; buy the short-term call back (possibly for a loss), or roll out to the June contracts prior to May's expiration. Rolling out consists of buying back the calls that are in danger of closing in the money, and moving out to the next expiration month (and possibly a higher strike price) so that time decay continues to work for us. Unfortunately, I didn't have a good example of a Covered Call play going against me recently, so perhaps we'll just have to periodically review our progress on this play.

This is not high-octane options trading, but it is a method for using what we know about technical analysis to juice up the returns of our long-term portfolio. During the two months we covered here, we took in $1700 in premium on a net investment of $8700. That alone represents an ROI of 19.5%. Annualize that, and we have 117%. If we were playing the same strategy with the underlying stock (which would have cost us $35,000), our covered call strategy would have netted us a whopping 4.9%, which comes out to 29% on an annualized basis. Nothing to sneeze at for sure, but a far cry from what is possible when using the leverage of LEAPS.

We have ignored the appreciation of the long-term leg in this example, but as of June expiration, the VAN-AH LEAP was trading for $17.80, which yields better than 100% by itself. Taking into account the continuously dropping cost basis, the ROI after the June cycle rests at 154% ($17,800/$7000). And it's only going to get better as we continue to write low risk front-month calls against those LEAPS. At the current rate, those LEAPS will have a negative cost basis long before expiration, making it tough to calculate the effective rate of return of the whole position. But I can tell you this. It sure is an easier way to sleep at night than trying to buy and hold cheap, far-out-of-the-money LEAPS on some fallen technology superstar of yester-year (like RMBS or JDSU) hoping against hope that the stock will come back, making your portfolio whole again.

I apologize for not adequately covering the downside of this strategy, but as you can see, I have already rambled on far too long. But we have yet to enter the July contracts, so there is plenty of opportunity. If you're lucky (and I'm not), there could be more education on this topic in a few weeks when the July expiration cycle draws to a close. If you're interested in continuing updates, drop me an email. If I get enough interest, I'll continue to update the trade over the coming months. In the process, you should get a good view of the good as well as the bad.

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