I am considering an Option strategy similar to a covered call except I would buy a LEAP instead of the stock?

Question

i.e. Yahoo is trading at about $27 i would buy a LEAP JAN09 17.5 strike at $11.15 and sell/write a JAN08 30 strike for $1.15 total cost is $10 ($1000 for the contract), and as the calls I write expire I would write new ones for the next month until I get exercized (in the first trade that would be at $30 for a $250 profit on a $1000 investment) or offset the LEAP close to expiration, always making sure the strike price was high enough so that if excersized I would make money counting in the premiums I collected. Basically this is similar to standard covered calls but more leverage (I belive the proper term for this strategy would be a "Diagonal Spread"). Is there any downside of using LEAPS instead of Stock that I am missing besides the obvious time constraint where I have a little over a year to pull a profit as opposed to buying the stock where I have as long as it takes? Any suggestions or tips are appreciated.

Answer 1

What you are doing is using a LEAPS as an alternative for the stock in a covered call which is, in fact, a diagonal spread.

Here is what the CBOE has to say about using a LEAPS as an alternative to owning the stock:

http://www.cboe.com/Strategies/BEL-CallsAsStockAlternative.aspx

You are correct you are getting leverage by using the LEAPS instead of the stock, but you are also paying for that leverage. Since you are effectively paying $28.65 ($17.50 + $11.15) per share when the stock is trading for less than that amount, you should subtract the stock price from $28.65 to determine how much you are paying.

One common mistake that people make when considering a strategy like the one you mentioned is that they expect to get the same premium every time a call expires and they sell another. Just remember that when the Jan08 call expires you may not be able to get nearly as much for a March $30 call and maybe not even that amount for a lower strike price. A decrease in implied volatility (IV) and/or the stock price may make it much more difficult to make a profit that you expect.

I am not trying to talk you out of trying this strategy. It is a fairly common strategy that is not overly dangerous. I just want you to know that even if your first few trades do work out well, the strategy is not as easy as it may appear at first. Don't trade a lot of contracts at a time until you have had some go bad on you and you have figured out how to handle it when the do.

Aside from the sentence "This is nothing like a covered call." I pretty much agree with what Bob siad in the first reply.

One last point I'll add is that there is no such thing as a "LEAP" in the options world. "LEAPS" is an acronym and always includes the final "S" even if you are only talking about a single contract.

Answer 2

This is nothing like a covered call. A leap is just another name for a call option with a longer than usual term. Therefore, you are indeed doing a diagonal spread between two options. i.e. you are combining some aspects of a calendar spread with a vertical spread.

The reason for using this strategy is to limit your loss on the long side to $11.15 if YHOO is trading below 17.50 in Jan09 versus the actual decline.

As far a making a profit. Will you be able to sell a Jan09 30 call for $10 in Jan08? If not you will be in the hole.

By selling the 30 call, you are limiting yourself to $3 of upside in YHOO while exposing yourself to $9.50 of downside on the stock. You are also going to lose a year of time value over the next year due to time decay.

Because this involves repeated trading, you are exposing yourself to multiple commissions (not included in your example).

Note: if you owned the stock of a dividend paying company, an advantage of ownership would be collecting the dividends. I know YHOO doesn't pay dividends, so this doesn't apply to this specific example.