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Educational Article

Questions on LEAPS Covered Calls - Part 1

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by Mark Phillips

It was with amazement that I watched the results unfold last Tuesday night. Having penned the second of what I expected to be a two or three part series of articles on Covered Calls on LEAPS, I was hoping for a few emails that would encourage me to continue covering the strategy on a periodic basis. What I received exceeded my wildest hopes, with more than 25 messages cascading into my InBox by 8pm. I would start to answer one question and by the time I finished, there would be another 3-4 messages waiting to be read.

By the time I went to bed that night, it was clear that I would need to start addressing the strategy on a regular basis just to answer the flood of insightful and prescient questions. Thank you to all that wrote in, requesting more information and a continuation of coverage on the AOL trade! While I will begin writing a column on the Covered Calls applied to LEAPS strategy every Wednesday (actually Tuesday this week, due to the holiday) from here on out (at least until there is no longer a demand for it), I thought tonight I would start to share some of the more popular questions. Complete with answers, this will allow all to benefit from the questions of the relative few.

So let's get to it, shall we?

Question: When you write a covered call on a leap is there any requirement on which strike price you sell the call on vs. the strike price of the leap you purchased? It sounds like you could buy an out of the money leap for cheap and sell the calls closer to the money for a bigger premium. Of course if the price of the stock stays the same or declines the leap would lose it's value, but you could eventually sell enough covered calls to pay for leap plus some.

Answer: This was actually a popular question, and that should come as no surprise. After the tech decline of the past year, there are lots of investors that purchased LEAPS on fallen tech darlings to profit from the eventual rebound. Unfortunately, the 'bottom' where these LEAPS were bought was just a way-station on the trip to a much lower stock price. Investors that neglected to use a rigid stop loss on these positions could be FAR underwater right now, with little hope of getting whole before expiration in January, 2002. The ability to write Covered Calls against these positions seems tempting, but alas, it falls into the category of "too good to be true". It turns out that the risk of the LEAP declining in value is the least of our worries.

While such a trade can be entered, when selling a call with a lower strike than the LEAP that we own, the broker will consider it to be a credit spread and therefore will require margin to cover the additional risk incurred by taking on the position. The goal that we are trying to accomplish by writing calls against our LEAP is to reduce the risk of holding the LEAP, by reducing our cost basis. Selling a covered call with a lower strike than the LEAP actually increases our risk, because of the possibility that the covered call could expire in the money, while the LEAP is still out of the money. With a large disparity in strike prices, you can see we are coming very close to selling naked calls - the highest risk option trade I am aware of. It has limited reward and unlimited risk. In a word, UGLY!

Let's go through an example to show why this is such a bad idea. Assume that we bought CSCO 2002 $40 LEAPS in January, as we expected that the stock would hold above the $35 level and then recover. Not believing there was much downside left in the stock, we neglected to set a stop loss. That was our first mistake as we watched CSCO get taken apart by the bears, dropping all the way to the $13 level. Now that the stock seems to have found a trading range, we decide to try to mitigate the damage by writing calls against the LEAP. We want time decay to work in our favor, so we will be using front-month options. In order to harvest any decent premium we need to be selling near-the-money options on a reversal from overbought. While we aren't there yet, it looks like CSCO will get close to $20 before reversing on this cycle so we target the $20 July Call. The premium we would receive as of Friday's close is a whopping $0.50. This hardly seems like much, but we're desperate to do anything to improve the balance sheet on this play.

If we go to sell the call, our broker wants to protect himself against the worst case scenario by requiring us to maintain margin in our account to cover the risk. That risk amounts to a dramatic event shooting CSCO to $40/share overnight. About as likely as Alan Greenspan showing up to testify before Congress in a pink tutu, but possible nonetheless. That move would have the LEAP finally at the money, but the sold call would be $20 in the money, handing us a $1950 (($.50 - $20)*100) loss on that position. Sure, the LEAP would appreciate somewhat, mitigating the loss on the covered call, but not nearly enough.

Put another way, we would take in premium of $50 (maximum reward) with a $2000 maximum risk. Those are not my kinds of odds! So while it is possible to sell calls in this situation, I don't recommend it. What we want to focus on in our trading is selling calls in such a way to reduce our risk. That means that we always want to sell calls with a higher strike than the LEAP that we already own, otherwise referred to as a debit spread. As long as we stick to this arrangement, our brokers should never require us to post any margin to initiate or maintain the trade.

If at this point you are still interested in trading credit spreads with LEAPS, make sure you understand the margin rules and the worst possible outcome in the trade before embarking down that path. Each brokerage will have slightly different margin requirements, so check with your own broker to determine your specific requirements.

Tune in tomorrow night, as I'll be addressing what was easily the most popular question received. Namely, "What do we do when the Covered Call is in danger of being exercised?" Another excellent question, and we will cover it in exacting detail.

See you then.

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