How LEAPS Can Enhance the Covered Call Strategy

LEAPS (Long-term Equity Anticipation Securities)

LEAPS are long term equity options that extend option expiration out up to 2 years. One strategy I use with LEAPS is the Diagonal Spread, which I like to call a Covered LEAPS Spread. This strategy takes advantage of leverage. It can be constructed to perform just like a covered call without requiring a buy of the actual stock as the underlying security. By replacing the underlying stock with LEAPS, one can leverage the trade to produce a higher return on capital. Be aware that LEAPS will lose value as expiration gets closer.

This is a great strategy to use on stocks that are trending higher or that might currently be moving sideways before going higher. It is designed to take advantage of the accelerating time decay of "close-to-the-money" short term options. It allows the trader to lock in a set return but can also generate a much higher return due to the Delta Effect, which can occur during the week of option expiration. The Delta Effect is most evident when the underlying asset goes up in value faster than the close-to-the-money short term option, which is held short against the underlying stock or LEAPS.

The Delta Effect can be very prominent during expiration because of the accelerating time decay of the short option. This effect produces additional revenue for the underlying option spread.

Let's look at an example that illustrates how low leverage is created when using LEAPS:

Traditional Covered Call

Buy-To- Open (BTO) General Electric (GE | Quote | Chart | News | PowerRating) 100 shares at $35.00 per share. Sell-To- Open (STO) 1 option contract of the April 08 $35.0 call (GEDG) for $.85 per contract. One option contract = 100 shares of stock. The option writer keeps the income (premium) from the call sell, $.85x 100 shares= $85.00. Return on Capital: $.85(premium) divided by $35.00 per share equates to a called or uncalled return of 2.42% or annualized equals 29%.

Covered LEAPS Spread

Instead of owning shares of stock as the underlying asset, a LEAPS contract is bought. (BTO) General Electric (GE) 1 contract January, 2010, $12.5 call (WGEAV) at $17.50 per contract. One LEAPS option contract = 100 shares. Just like the traditional covered call (STO) 1 option contract of the April, 2008 $35.00 call (GEDG) for $.85 per contract. The option writer keeps the premium from the call, $85.00.

Return on Capital: $.85 (premium) divided by $17.50 per LEAPS call contract equates to a called or uncalled return of 4.86% or annualized equals 58%. By replacing the underlying stock with a long LEAPS contract the trade return doubled due to the use of leverage. The most common way to leverage trading performance has always been the use of a margin account to trade stocks. However, this means of leverage has several disadvantages when compared to LEAPS.

- The trader puts up a fraction of the stock's purchase price and is required to borrow the balance from the broker and pay interest on the borrowed amount. The interest rate on borrowed money can change overnight.

- The curse of the investor who purchases stocks on margin is the dreaded margin call. The loan extended by the broker is guaranteed by the stock purchased. If the stock drops in value the trader will have to put additional cash into the account to make up the short fall. If he fails to do this, the broker has the right to sell his stock without consent in order to cover the margin loan value.

- Purchasing LEAPS calls eliminates the possibility of a margin call, since the purchased options have to be fully paid for when the position is initiated.

- Staying power- The trader who borrows is more likely to trade out of a position when things are at their worst and prices at their lowest. Many times this can be at the bottom and the trade will come back but the trader is now out. By buying LEAPS the buyer is better able to define risk because one must pay in full for the whole position.

The LEAPS buyer's cost of financing is known and fixed. It is the cost of the LEAPS option. When on margin this is not known. When using LEAPS it is very important that trades are constructed correctly. This is especially true when trading Covered LEAPS. The Delta Effect is one great advantage of the Covered LEAPS strategy and to use it effectively the spread must be constructed for a positive called return at expiration.

Larry Gaines, founder of CallsandLeaps.com, has an extensive knowledge of the equity and option markets with over 25 years of trading experience. His experience includes managing one of the world's largest international oil trading companies for over 10 years. He first started trading options 20 years ago on cargoes of North Sea, Brent crude oil. His specialty is trading covered calls and LEAPS.