Covered call writing is generally thought of as a conservative option writing approach because the call options that are sold for the premium are not naked. Covered call writing involves owning the underlying - which may be stock or futures contracts - and selling the call options against that underlying position.

Should the covered call option get in the money (ITM) with a rise of the underlying, the worst that can occur is that the stock position gets called away. In such a scenario, the investor still gains because the premium is retained as profit while the stock position rises to the strike price of the covered call option, the point at which the writer would be assigned during an exercise.

Key Takeaways

  • A covered call is a popular options strategy used to generate income in the form of options premiums.
  • To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
  • It is often employed by those who intend to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term.
  • For those seeking to boost covered call returns, using a LEAP option as the underlying may be a smart strategy.

Covered Calls

Covered call writing is typically done if the investor maintains a neutral to bullish outlook and plans to hold the underlying long-term. Since the calls sold are "covered" through ownership of the underlying, there is no upside risk in selling (shorting) calls. However, the problem arises on the downside, where a large unexpected drop of the underlying can result in large losses, as the call premium collected in a typical covered call write affords an investor very limited protection.

Since stocks can drop quite far quite quickly, the small amount of call premium collected in most covered-call writes is very little for hedging downside risk. Fortunately, there is an alternative if you want to reduce downside risk but still collect call premium with covered writes and have upside profit potential.

One covered call approach that offers the potential for improved overall performance, known as the "surrogate covered call write", uses stock option LEAPS instead of stock as the underlying asset.

Example: The Traditional Covered Call Write

To demonstrate this surrogate strategy, first consider a traditional covered call hypothetically written on J.P. Morgan (JPM) shares. Assume that JPM stock is trading 35.72. If an investor were mildly bullish on JPM, they could apply a traditional covered call, which has some modest room to profit from more upside.

If the investor wanted to hold a six-month covered call, they could sell the slightly out of the money 37.50 call, which is trading at $1.60 If JPM closed at expiration just at the strike price of the 37.50 call (the maximum profit point), there would be a profit of $1.78 per share plus the entire $1.60 profit for the call option that was sold but which would have expired worthless. The maximum profit is thus $3.38 per share. There could also be an additional small gain from any dividends earned during this six-month period, which is not factored into this case.

Traditional Covered Call Write
JPM Price July Call Strike Call Premium Maximum Profit
35.72 37.50 $1.60 $3.38

Substituting a LEAP Option

For the surrogate approach, instead of buying JPM shares, the investor could purchase a deep-in-the-money LEAP call option with a strike price of 25 expiring in twenty-four months, which for our example is trading at $10.70. In other words, instead of owning J.P. Morgan shares, a two-year call option LEAP acts as a "surrogate" for owning the actual underlying.

Ideally, this strategy works in a mature bullish market, which is usually accompanied by low implied volatility. We want a low volatility environment because LEAPs have a high vega, or a larger price sensitivity to changes in volatility. LEAPs, otherwise, have the same basic pricing fundamentals and specifications as regular options on stocks.

The LEAP premium represents intrinsic value only (i.e. very little time value) because the option is so deep in the money. Since there is little time value on this option, it will carry a delta close to 1.00. Owning the LEAP thus acts as a surrogate to owning the actual shares, but ties up considerably less capital.

The LEAP owner can now sell the same JPM 37.5 call for $1.60 against this LEAP. If JPM closes at $37.5, the maximum profit of $3.38 would be reached, the same maximum profit of the previous example but requiring less upfront capital. Therefore, there is a greater return on capital employed (ROCE).

LEAP-Based Covered Call Write
Jan 2006 25 LEAP Price July 37.50 Call Price Call Premium Maximum Profit
10.70 1.60 $1.60 $3.38

The LEAP ties up just $1,070 (10.70 x 100 shares in a call contract), which is around one-third less than the $3,572 required in the traditional covered call. If one could establish a long position in the underlying for less than one-third the required capital for a traditional covered call write, it would make sense to convert to a LEAP-based strategy simply on this basis - although, dividends would ultimately have to be factored in to create a fair comparison. However, the downside risk story is substantially altered, which is the more important issue.

Maximum Downside-Risk Reduction

Let's say that at expiration, JPM closes at 30 instead of at the maximum profit point assumed above. Table 3 below summarizes the losses for both covered call positions. As you can see, the traditional covered call write loses $572 on the stock position ([$35.72 - $30] x 100 shares = $572). This loss is offset partially by the profit on the expired-worthless July call, leaving a net loss of $412 ($572 - $160 = $412).

For the LEAP-covered write, meanwhile, the position would show the same loss amount, as the delta on the LEAP closely mimics the long stock position when in the money. Since the LEAP call has a strike price of 25, it is still well in the money at 30. It would have, therefore, lost $412 ($572 - $160 = $412). However, should the stock fall lower, the advantage shifts to the LEAP strategy.

For example, should the close at expiration of JPM be at 25, the loss on the traditional write would be $1,000 larger at $1,412, but the LEAP-covered write can lose a maximum of only $10.70 minus $160, or $910. It would also actually show a lower loss at 25 due to the remaining time value on the LEAP, which would be about $150.00, and the impact of volatility which we have not examined yet. This is where it gets more interesting as an alternative strategy.

Loss comparison if JPM falls to 25
Traditional Covered Call Write Loss LEAP-Based Covered Call Write Loss LEAP-Based Strategy Loss w/ Volatility Edge
$1,412 $760 $480

Therefore, at a share price of 25 upon expiration of July 37.50 calls, if we assume there is approximately $150 in remaining time premium on the LEAP call, losses would be $760. That is nearly 50% less than the -$1,412 on the traditional write (see Table 3).

Volatility Advantage

The LEAP strategy is even more attractive when we take volatility into account. Since LEAPs have a high vega, a rise in volatility would raise levels of intrinsic (i.e. time value) on a long LEAP position, such as the one we assume for this article. At the time of this writing, JPM volatility was at a very low level - so low, in fact, that it has been this low only 2% of the time during the past six years. Therefore, the JPM volatility has a good chance of rising during the 24-month period before the LEAP expires and even before the covered call expiration date, helping us out on the downside.

Since implied volatility and stock prices have an inverse relationship, a drop of any sizable magnitude would cause a spike in volatility - which we can model - and would further reduce the maximum loss on our LEAPS surrogate covered write strategy. If we suppose JPM falls to the price of 25, for example, there would be a substantial rise in volatility. Assuming even a modest increase in volatility, there could be a large benefit to the value of the LEAP.

Other Considerations

If interest rates were to rise, the position would experience further reductions in the maximum loss, since call LEAPs rise in value when rates rise. But dividends would have to be factored in as well on the traditional covered write, which would reduce maximum losses there.

In the traditional covered call, if JPM were to fall to 25, some investors might be forced to liquidate the position for fear of losing even more. However, with the LEAP-covered call write, this fear is somewhat removed. For example, if the share price is 25 at expiration of the covered call, the LEAP will still have some time value left so there is no pressing reason to sell the LEAP, especially since it still has many months left before it expires.

These other factors aside, it's clear the LEAP-covered call write strategy would seem to offer a better risk/reward scenario. But there is one other significant advantage that is not all that apparent at first.