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Odds & Ends From the Land of LEAPS

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Odds & Ends From the Land of LEAPS
by Mark Phillips

As we wind down the final week of summer, the wisdom of sitting out for the last 2 weeks of August is becoming increasingly clear. Choppy trade, gap moves and sharp reversals are a seemingly daily occurrence, while the bulk of Wall Street's professionals grab a little bit of vacation time before getting back to work after Labor Day. For those of you that have been trading over the past couple weeks, I hope you've found the insights of the Market Monitor team beneficial. While I haven't been actively trading myself (Hey, I'm entitled to a bit of R&R, right?), I have noticed that they're doing a bang-up job of helping all who are interested to navigate these volatile markets.

Since I haven't been focused on trading, it has given me the opportunity to catch up on my backlog of email and get a feel for some of the questions that seem to be nagging at some of my readers. That process guided me to last week's topic on Collaring, which hopefully many of you found useful before this latest downward leg in the markets got started.

Monday's Trader's Corner was likewise stimulated by a fresh batch of questions relating to the difference between Stop and Stop Limit orders, and how to apply them. Since I seem to be on a roll and we only have 2 more days before the long holiday weekend, I thought I'd round out my August commentary with an answer to another question that has been cropping up fairly regularly.

I've been running the LEAPS column for over 2 years now (Wow! Has it been that long?) and one of the important changes we made last year was to start talking more about how to implement covered calls on LEAPS. To be fair, it isn't really a covered call when we write a short-term call against a LEAP in our account. It is really a calendar spread (either vertical or diagonal), at least as far as your broker is concerned. What is important here, is that if done properly, the position behaves exactly like a standard covered call. But if we don't initiate the LEAP position and then the covered call against it in the right way, we end up having to maintain margin in our account to cover the spread.

First off, if this strategy sounds interesting to you, but also new, then let me point you to an introductory article I wrote last year entitled, Covered Calls on the Cheap. That's where I laid out the basic strategy for writing short-term calls against LEAPS. As you can see, it is little different from writing short-term calls against the underlying shares in the standard Covered Call strategy.

The nature of the question I want to address tonight is the fact that we want to select a different strike LEAP to purchase if we are planning on selling short-term calls against it to offset our initial cost. Let's say that we are looking to buy LEAP Calls on the QQQ, with it currently trading at $23.48. If this is going to be a simple Buy-and-Hold trade, then we would likely want to target the $25 strike. That way, we get the benefit of both Gamma and Delta working in our favor, as the QQQ appreciates through the strike of our LEAP.

On the other hand, if we intend to sell short-term calls against our LEAP, then we want to select a different strike, either ATM or quite possibly ITM for our LEAP. The reason is that we want to avoid having to maintain margin in our account to cover the difference between the strike of the LEAP and the strike of the sold call. In the case of the QQQ, if we bought the $25 2004 LEAP Call, then we are limited to selling the $25 strike or HIGHER for the front month if we want to avoid maintaining margin on this trade. The simpler solution is to initially purchase a lower strike LEAP on the QQQ, one that gives some flexibility in which short-term call we choose to write. For the sake of argument, if we had purchased the $20 LEAP, then we have the freedom to write calls nearer to the money, consequently taking in more premium. Keep in mind that we don't have to write that call close to the money, but sometimes we want the flexibility to do so.

If I've lost you in this discourse, then I most humbly apologize. Let me direct you back to the archives for a couple of Q&A articles on the subject of Covered Calls on LEAPS.

Questions on LEAPS Covered Calls - Part 1
Questions on LEAPS Covered Calls - Part 2

That should have given everyone a good enough refresher that we're all on the same page and now we can proceed to the central issue that I want to cover. When we list a new LEAP Call play in the Watch List on the website, we list 2 strikes for each expiration year. That has generated some confusion in the recent past, as some readers have wondered if that means they should buy the first LEAP and then sell the one with "** Covered Call **" next to it. If you've been following the discussion so far, then you probably already have the answer figured out, but let's walk through it, shall we?

Here's a typical example of the recommended LEAPS listed at the end of one of the LEAP Call write-ups.


BUY LEAP JAN-2004 $50 LMO-AJ
BUY LEAP JAN-2004 $45 LMO-AI **Covered Call**
BUY LEAP JAN-2005 $50 ZMO-AJ
BUY LEAP JAN-2005 $40 ZMO-AH **Covered Call**
The way to use this information depends on the trading strategy that you have chosen to employ. If you are just a simple Buy-and-Hold LEAPS investor, then you will simply use either the LMO-AJ or ZMO-AJ LEAPS. These LEAPS are for the MO LEAP call, so with the current price of $49.31, you can see that those strikes are now near-the-money. But we want to enter the play back down near the $46 level, at which point, the $50 strikes will be a bit out of the money. That will give the standard Buy-and-Hold investor the ability to profit from both Delta and Gamma as MO gets headed north again.

But for the trader that wants to write short-term calls against their long LEAP, the $45 strike makes more sense. This enables us to write front-month calls against the LEAP, all the way down to the $45 strike, which should continue to generate a decent premium, even if MO temporarily falls down into the $42-43 area, the site of strong support. Contrast this to the situation we would be in, if we bought the $50 LEAP, MO declines to $43 and we want to write a call against the LEAP. I don't think I need to tell you that the premium collected from that transaction would scarcely cover the commission required to sell the call. That would only leave us with the option of writing the $45 front-month call and then maintaining margin to cover the risk between the strikes.

Hopefully, I've made it clear that the additional strikes listed (those with the **Covered Call** notation), are just there to aid you in your selection of the appropriate strike, depending on your chosen trading strategy.

Next week will see us in a new month, volume will be back in the markets and hopefully rationality will prevail. (ok, I got a little carried away there...) At a minimum, I'll dream up some new and exciting topics for us to share. In the meantime, keep those questions coming!

Have a Great Holiday Weekend!

Mark

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