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 assets—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 asset, 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.
The strategy described below uses long-term equity anticipation securities (LEAPS) instead of stocks as the underlying asset.
- A covered call is a popular options strategy used to generate profits 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 long-term equity anticipation securities (LEAPs) as the underlying asset may be a smart strategy.
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.
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 affords an investor very limited protection.
Since stocks can drop 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 "leveraged covered call," uses long-term equity anticipation securities instead of stock as the underlying asset. This strategy may also be known as the "poor man's covered call," a "fig leaf," or a "surrogate covered call write."
Example: The Traditional Covered Call
To demonstrate this strategy, first, consider a traditional covered call hypothetically written on JPMorgan Chase & Co. (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|
Substituting a LEAP Option
For the leveraged covered call 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 JPM 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 close equivalent 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 as in 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|
The LEAP ties up just $1,070 (10.70 x 100 shares in a call contract), which is around one-third of 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, 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 the options' expiration, JPM closes at 30 instead of at the maximum profit point assumed above. 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, the position would show the same loss amount. This assumes the LEAP maintains a delta score of 1.00 so that it closely mimics the long stock position. 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 $500 larger at $912, but the LEAP-covered write can lose a maximum of only $10.70 minus $160, or $910. It is worth noting that the LEAP strategy could also show a lower loss at 25 if this scenario did NOT occur at expiration of the LEAP. That would mean there was some remaining time value. If we imagine that the LEAP still had $1.50 in time value, then the $150.00 in remaining premium would reduce the expected loss.
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 extrinsic (i.e., time value) on a long LEAP position, such as the one in this example.
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 covered call 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.
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, 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 strategy would seem to offer a better risk/reward scenario.
The Options Playbook. "Leveraged Covered Call | Fig Leaf Call."