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Questions on LEAPS Covered Calls - Part 2

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by Mark Phillips

Welcome to another episode of "Stump the Rocket Scientist." While that term is a bit of a stretch, those of you that know me are aware that I did spend a decade in a prior life as a Control System Engineer for NASA. All that means is that I experienced government bureaucracy at its best and have developed a true appreciation for the unfettered nature of trading and writing for a living. So keep those emails coming. Your questions are the source for some of my best writing ideas, and as long as I have interesting topics on which to write, I can continue to share my knowledge through cyberspace. It sure beats working for a living!

Yesterday, I promised to cover the downside of the LEAPS Covered Calls strategy. So without further adieu, let's get to it. Rather than copy any of the well-stated questions requesting coverage of this side of the trade, I thought I would take a more direct approach, stating the problem and then providing an appropriate solution.

As I see it, there are 2 possible ways in which this trade can go against you. The first is that the stock declines significantly, dramatically eroding the premium of your LEAP. While that doesn't create any issues with respect to the sold call (it will very likely expire worthless), but we can't just sell our LEAP on a stop loss, as that would leave us short a naked call. We definitely want to avoid that situation.

So here is the simple plan of action. We should always have a stop loss on the LEAP (typically below significant support, or based on a maximum loss we are willing to incur), at which point we want to sell the LEAP. Instead of placing an order just to sell the LEAP, we need to place an order to close the spread by buying back the covered call and then selling the LEAP. Some brokers will allow you to exit the trade in a single transaction, while others will require you to buy back the covered call before shedding the LEAP. Check with your broker to determine exactly what options are available to you.

Falling back on our tried and true AOL example, we will use the stop loss listed in the LEAPS Portfolio, since at $48, it is just below the $49-50 support level that we expect to act as a launching pad for the stock's eventual recovery. Recall that the LEAP we own is the $40 2003 LEAP. As of this writing we are short the $55 July call (more on that down below). Assume that AOL warns that they will miss earnings estimates by a country mile and over the course of the week, the stock drops to $49, then $48, and finally on Friday, falls through that level.

My Good-Til-Cancelled (GTC) stop loss order is already placed with my broker, and when that $48 level is breached (I usually avoid placing my stops at round numbers, and actually have the stop placed at $47.75) the Covered Call is bought back for a pittance and the LEAP is sold for a profit. If we assume that I received $16.50 when I sold the LEAP, and it cost me $0.25 to buy back the Covered Call, I can calculate my total return on the position. Cost Basis = LEAP Cost ($8.70) - May CC ($0.70) - JUNE CC ($1.00) - July CC ($2.00) + Buy Back July CC ($0.25) = $5.25. So my profit is $16.50 - $5.25, for a total profit of $11.25 or 174%.

Not bad for a 3-month hold, huh? And this was our exit strategy for the case where the overall position went against us, forcing a premature exit. Granted, the final closing prices are educated guesses, but it is close enough for government work, don't you think?

This brings us to the other way in which the strategy can go against us, that the stock moves through the sold strike, putting us at risk of having the call exercised. While my exit strategy is fairly simple, there are many different ways in which this situation can be handled. Let's cover my approach and then I'll address some special situations.

Falling back on the AOL example, let's start by updating the position. We left off last week after the June call expired worthless and I was looking for an entry point to sell the July call. Due to writing that article some time ahead of publication, by the time it went to press, I had already sold the July $55 call at the close of trading on June 21st. Although I may have jumped the gun somewhat, the stock was once again looking overextended and I was expecting to see weakness heading into the July earnings season. Resistance looks decent at $55 and even stronger at $57. With Stochastics entering overbought territory, and price exceeding the upper Bollinger band on the second of two heavy volume up days, I decided to play a little closer to the edge, expecting an imminent pullback. So as prices peaked at the close on Friday, I sold the July $55 calls for $2.00.

So now I need to figure out my exit strategy. If AOL continues higher, at what point would I exit the Covered Call, and how would I go about doing it. Since I took in $2.00 from selling the Covered Call, I can allow the stock to go all the way to $57 at expiration before I have to be concerned about a loss on that leg of the position.

So my stop loss on the covered call will be set at $57. A move through that level and I will need to consider buying back the sold call. In the meantime, I can let time decay work in my favor and the first week is certainly shaping up nicely. No matter how it plays out though, I am in a good position. If the July call expires worthless, I get to repeat the process next month. If AOL moves above $55 and looks like it will top $57 before expiration, I will need to contemplate an early exit of the Covered Call by buying it back, probably at a loss. But the good news is that I have a fat profit in the overall play and have another interesting development to write about in this column.

But let's talk specifics. I manage my covered call with a GTC stop order so that if I'm not watching the stock when it makes a move against me, that part of the position will be closed without the interference of emotion that so frequently clouds our judgment. But then I am faced with another decision. I may want to consider turning around in fairly short order and selling the next higher strike, possibly in the next expiration cycle, depending on the amount of time remaining in the July expiration cycle. Of course, I will still want to follow my general rule of selling into strength when the stock appears to be topping out in overbought territory, without developing a new strong uptrend. Remaining disciplined should allow me to ride this trade for many months into the future, eventually working my cost basis to zero. Of course, you may want to root for my covered call to move through resistance because then you will know I'll be writing the details of how I managed the exit from the trade in real-world conditions.

That about wraps up the ordinary conditions, but before I conclude this evening's rambling, I thought I would share a rather unusual case brought up by another of my faithful readers.

The basic question is "What happens if the company you have been writing covered calls against receives a premium buyout offer and the price shoots up $20 overnight? How do you gracefully exit the position?"

Simply put, we will shortly close the entire position, buying back the covered call and selling the LEAP. Since the LEAP has a higher delta than the short-term call, it will appreciate more on such a dramatic move. There would be nothing wrong with closing the entire position the day after the buyout announcement juiced the stock price.

But if we are 3 weeks from expiration of the sold call, we may be able to milk just a little more profit from the trade by watching the actual price of the short-term option. While an equity call can be exercised at any time in the expiration cycle, it is unlikely to happen until such time as all of the time value has been squeezed out of the option. So by watching the option price and regularly checking how much time value remains, we can more precisely time our exit from the play. When the time value component (total premium minus intrinsic value) drops to $0.25 or less, we have milked just about all we can from the play and have reached the optimum exit point.

One final wrinkle to the strategy involves the issue of what to do in the unlikely case that our sold call actually is exercised. This is another issue that will likely vary on a broker-by-broker basis, so the best course of action is to check with yours for specifics. But if you are forced to deliver the shares at the strike price of the sold call (your broker will likely short the shares in your account), you should be able to turn around and buy them back with the combined proceeds of the sale of the shares and the premium received from the sold call. This leaves your LEAP intact, putting you back on the road, selling front-month calls in the quest to reduce your LEAP cost basis to zero.

Happy Trading!

Mark
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