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Educational Article

AOL-Rest In Peace

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By Mark Phillips

I had originally intended to pen another educational article on the topic of LEAPS covered calls today, but the market had other ideas, especially after AOL issued its earnings report this morning. On the surface, things were looking good as the company beat estimates by 3 cents. But revenues came up short of expectations, prompting investors to extract their pound of flesh from the stock and forcing me to bring my successful AOL trade to a close.

So those of you that have been waiting for me to detail how we exit our Covered Call LEAPS play under less than ideal circumstances get their wish this evening.

The way we handle exits from our LEAPS Portfolio plays when our stops are triggered, is to wait for the closing price to execute the trade. And that is how it will be reflected when we formally cover the drop this weekend. But the precipitous drop at the open this morning had me closing out my LEAPS Covered Call play shortly after the open, as it was clear there would be no rebound to save me this time.

Since I prefer to exit my spread trades one leg at a time (similar to the way I enter them), the first order of business was to close out the short-term call. Most traders will want to either exit the entire position as a spread (if their brokers provide this ability) or leg out as I do, which avoids the situation of being short a naked call after selling the LEAP.

So I pulled up the real time quote on my July Call, and found that I could get out for a nickel. If it weren't for the precipitous drop in AOL this morning, I would have been happy to let the call expire worthless on Friday, but I didn't have that luxury. So I bought back the 10 JUL-55 calls (AOO-GK) for a total of $50. Not bad on the CC side of the trade, but then I had to close out the LEAP, and it was painful to have given up some of the accrued gains that had been present a few short weeks ago. As recently as June 28th, my LEAP had been trading as high as $19, and by the time the closing bell rang today, my $40 2003 LEAP was worth just over $13. That's quite a haircut and I was glad I got out when I did.

By the time I had live quotes for the LEAPS and had closed out the short-term call, my $40 Jan-2003 LEAP (VAN-AH) had fallen to $14.20. I quickly put in my market order and was more than happy to get filled at $14.00, especially as I watched both AOL and my LEAP continue to decline throughout the market day.

So let's review the history of our play. Recall that I entered the long side of the position when AOL began its long rebound on April 4th. Every once in awhile the blind squirrel finds an acorn and this was my acorn, picking AOL very near its low. Anyways, I picked up the Jan-2003 $40 LEAPS for $8.70 and sat back to let the LEAPS appreciate, which they did in quite a hurry. Beginning with the May expiration cycle, I started selling covered calls against my LEAPS, taking in premium in my attempt to move the LEAPS cost basis down to zero.

Well, I didn't quite do that well, but after selling the May, June and July calls, I managed to move the cost basis of the LEAPS down to only $5.05 (after taking in a total of $3.70 in call premium and then buying back the July calls this morning for $0.05). So with a cost basis of $5.05, and a closing price of $14.00, I netted $8.95 profit per contract for a 179% profit on the position in about two and a half months. That's not half bad! This is really a good case study of the power of using covered calls in conjunction with our LEAPS. If we had just taken a Buy-and-Hold approach with our AOL LEAP, using the same entry and exit points, our results would have been respectable but certainly not stellar. With a cost basis of $8.70, and a closing price of $14.00, our return would have been $5.30 or 61%.

This is only one example, but it paints a clear picture of what can be accomplished by using more active management of our LEAPS plays. Each trader could have found different ways of managing the AOL LEAPS play. One alternative using just the Buy-and-Hold approach would have been to exit the LEAP for approximately $19 in late June, which would have provided a profit of more than $10 or 118%. But our intent here was to detail a LEAPS covered call play from beginning to end, providing a roadmap for traders looking to employ the strategy in their own portfolios.

I'm sure there are some unanswered questions, but I think this series should give us a good starting point for discussing the strategy on additional attractive candidates from the LEAPS portfolio in the weeks and months ahead. As always, keep those questions coming. Education is our primary goal here, and with your assistance, we'll continue down that path, following specific examples as those opportunities present themselves. With the growing list of stocks that have been severely beaten down again in recent weeks, the covered call strategy will likely prove quite valuable for those willing to invest the time necessary to employ the strategy in the months ahead. Now that we have brought the AOL example to a close, I'll start focusing on other candidates for this strategy in the weeks ahead.

Have a Great Week!

Mark
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