Covered call with LEAPs

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Greg Pugh

How to Use LEAPS as Stock Replacement

Some investors are getting started with a small account. However, these investors want to make some extra cash to pay some bills or to build up their capital. They can sell calls on lower priced stocks as it takes less capital to purchase 100 shares of stock. This is not the only way to achieve income on a smaller portfolio. They can use LEAPS (long-term equity anticipation securities) as a stock replacement in covered call trades.

Just like a covered call trade, LEAPS (yes it always has an “S” which stands for security) can be purchased instead of the underlying stock which a call can be sold against to provide income. LEAPS are similar to options except they have a longer time to expiration. LEAPS usually expire from 1 to 3 years from the time of purchase. The tradeoff is that you can purchase a LEAPS with 1-3 years of time at a lower cost than purchasing the stock.

The risk profile is very similar between a stock purchase or a LEAPS. If you buy a stock for $50 then your risk is $50. The same is true for a LEAPS. If you buy a LEAPS contract for $20 then your risk is $20. In both cases, your total investment amount is at risk. The big difference is that LEAPS have an expiration date while stocks do not. Since LEAPS have an expiration date, they can be purchased at a lower price than the underlying stock.

When you purchase a LEAPS contract, you control 100 shares of the underlying stock. Just like a option call, LEAPS give you the right, but not an obligation, to purchase the stock at any time before expiration at the strike price you purchased.

For example, Pepsi (PEP) is trading at around $69.00 at this time. Your cost to purchase 100 shares of UA will be $6,900. You can purchase a Jan 2013 call at the $70 strike price for $4.35 per contract. This LEAPS will cost a total of $435.00. This is a significant difference in the initial investment that is at risk. The January 2013 call has 556 days until expiration. You now have the right to purchase 100 shares of Pepsi stock at $70.00 anytime over the next 556 days.

To complete a covered call on PEP, you can sell one August 2011, 38 days til expiration, call at $0.84 per contract. This is $84.00 in income for a total investment of $435.00. This is a static return of 19.31% over 38 days. This is extreme leverage that LEAPS offer to the investor. If you purchased the stock instead of a LEAPS, your return would be 1.22% because your investment would be $6,900. Also, your risk would be $6,900 for the stock versus just $435.00 for the LEAPS.

The bottom line: LEAPS lower your total investment compared to the underlying stock and leverage your total return potential. This is great for those wanting income when investing with a small portfolio or those wanting to leverage their return.

Covered Call with LEAPS

When entering a covered write with a LEAP, the investor hopes that the short-term call written against the LEAPS will expire worthless. The investor can then “roll” the short-term call to further-out months with the goal of collecting additional premium month after month.

There are three risks with covered call – LEAP strategy:

Stock price decline Assignment (creates a short stock position) Stock price rise can reduce profit

Managing actions should be planned in advance.

If the price falls too fast you have these options:

Close position and realize the loss. Roll Down and Out by covering (buying back) short call and then selling lower strike call with later expiration date. Maintain position – hope for price rise. Let short Call expire and keep LEAPS Call.

What if the short call is assigned when stock price rises above call strike price? Here are some options:

Close the whole position Buy stock (to cover): stay long LEAPS Call Buy stock (to cover) & sell another Short-term Call (now have a new LEAPS covered call).

If the stock price rises too much, your profits will be reduced. Why are profits reduced if the stock price rises too much?

It’s called the “effective price” concept. If a call is exercised, then stock is purchased. The effective purchase price of the stock is the strike price plus the call premium. For example:

Buy a 50 Call @ $3.00

If the call is exercised:

The total cost of the stock is $50 + $3 = $53

$53 is the effective price.

The following example shows how to calculate effective price:

Stock XYZ @ $53.80

Long 1 XYZ 18-month 45 Call @ $10.60

Short 1 XYZ 60-day 55 Call @ $1.25

                     Strike  +   Call Px  =   Eff Px

55 Call 55 + 1.25 = 56.25 Sell

LEAPS Call 45 + 10.60 = 55.60 Buy

                       Maximum Profit = +0.65

Profit at expiration of short call can be higher if there is time premium in the LEAPS call.

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