How to Use LEAPS for Covered Call Writing?
Long-term Equity Anticipation Securities (LEAPS) a certain options contracts that have expiration dates of more than one year. Typically, a LEAPS’s expiration date can extend up to three years. Besides its extensive tenure, LEAPS functions like other listed stock options.
To cushion major losses, investors can combine LEAPS with a covered call-writing strategy. Read till the end to know how to use LEAPS for covered call writing.
What Are Covered Calls Writing Strategy?
Traders usually opt for a call option at a set price and expiration date against security that they own. This is referred to as the covered call options strategy. Seasoned traders use covered calls when they do not expect large price fluctuations and want to book in profits.
This strategy is constructed by holding a long position on a stock and selling a call option of the same asset. Thus, it represents the same size as an underlying long position. Usually, call options allow traders the right to sell shares at the expiration date for market price. With covered call writing, a seller or writer can sell this right to a buyer in exchange for cash.
How Can You Use LEAPS in Covered Call Strategy?
As we already know, LEAPS are long-term options that expire after 1 year. When a trader uses LEAPS on a covered call they have to pay more premium as the expiry date of the covered call increases.
Traders can use LEAPS as underlying assets along with their covered call strategy to boost their returns. To comprehensively understand the working of the covered call strategy with LEAPS let’s consider the following illustration.
For instance, Reliance India is trading shares of ₹ 2,869.19. A mildly bullish investor can apply for a traditional covered call to earn profit from price appreciation.
They can also opt for a LEAP option. Here, instead of buying shares of Reliance, the investor can purchase a deep-in-money LEAP call option with a strike price of ₹2,049 for 1 year.
The LEAP strategy performs well in a bullish market with low implied volatility. LEAPS are highly sensitive to price changes in underlying assets. As a result, a low volatile environment is important. As these options are deep in the money, they tend to represent very little time value. Here, their delta value will be close to ₹81.98.
The LEAP owner can now sell the Reliance call option for ₹3074.13 against his LEAP for ₹131.16. If Reliance closes at ₹3074.13, the maximum profit will be ₹277. Owing to this, the rate of return on capital employed will be higher.
Risk Reduction Strategy
Now, if Reliance closes at ₹2459.31, the standard call writing strategy results in a loss of approximately ₹46,890 in stock position. This can be cushioned by the profits that an investor makes through his/her expired call. This makes his/her net profits as follows
₹(46,890-131.16)= ₹ 46,758.84
Benefits of Using LEAPS for Covered Calls
Here are some benefits that traders can enjoy by using LEAPS.
- Any declining stock will get enough time to recover with LEAPS.
- These are less costly than buying and trading with stocks. Traders can use the remaining cash to generate additional cash.
- As they have low time value and deep-in-the-money ownership, the cost of owning options is much lower than owning stocks.
Risks Associated with LEAPS and the Covered Call Strategy
Here are certain risks or demerits that investors must consider before opting for LEAPS.
- There are low chances of making profitable trades with a forced assignment.
- Investors will not receive stock dividends.
- It is more difficult to get approval from brokerages for this type of trading.
To conclude, you can observe that the LEAP-covered call strategy can offer a better risk-to-reward ratio than other options strategies. Investors consider covered call writing with LEAPS a suitable way to invest in stocks without paying for the ownership. However, traders should assess both pros and cons along with their risk appetite before using this strategy.
Frequently Asked Questions
What is implied volatility?
Implied probability is the market forecast about the probable movement of a security’s price. Time value, demand, and supply are major factors affecting implied volatility.
What is delta in options trading?
Delta is the amount of price changes an option contract will witness based on its underlying asset’s price. It can be positive for call options and negative for put options.
What is Vega in options trading?
Vega is the measurement of an option’s price value based on the implied volatility of an underlying asset. Long options have positive vega and short options have negative vega.
Are covered calls profitable?
Like every other trading method, the profitability of covered calls will vary on an investor’s implementation of the strategy. If the spot price is equal to or near the strike price of a covered call, one can earn good returns. A trader must assess both the pros and cons of covered calls before investing.