Covered call and leaps a wealth option

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 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.

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.

I have worked out a covered call writing approach that offers the potential for improved overall performance.

I call it the "surrogate covered call write", and it uses stock option LEAPS instead of stock as the underlying. The Traditional Covered Call Write Let me demonstrate my surrogate strategy by first illustrating a traditional covered call write on J. On Dec 16,JPM closed at If I were to remain bullish on JPM, I might want to apply a traditional covered write, which has some room to profit from more upside. Let's compare the two ways we could apply the covered write: First, let's set up the traditional write.

Covered Calls and LEAPS -- A Wealth Option by Joseph R. Hooper, Aaron R. Zalewski & Robert Kiyosaki on iBooks

If we want to do a six-month covered call write, we could sell the just out of the money Jul If JPM closed on expiration day Jul 17, at the strike price of the There would be an additional small gain from any dividends earned during this six-month period, which is not factored into this case.

Table 1 - Traditional Covered Call Write prices from close of trading December 16, In other words, instead of owning J. Morgan, I will own a two-year call option LEAP - a long term option that trades on the underlying and acts as a surrogate for owning the underlying and expires on Jan 22, Ideally, this strategy works in a mature bullish market, which is usually accompanied by low implied and statistical volatility. We want a low volatility environment because LEAPs have a high vega, which means they can increase in value when volatility increases, or fall in value if volatility declines, a point to which I will return below.

Covered Calls Book - Investing Techniques | Compound Stock Earnings

LEAPs, otherwise, have the same basic pricing fundamentals and specifications as regular options on stocks. This price represents intrinsic value only i. Since there is no time value on this option, and delta is at or very near 1. I will now sell the same Is the stock market crashing soon If JPM closes Jul 17, on expiration day money make the world go round song download the strike price of the July Fair market value stock appreciation rights, there is greater return on required capital.

I am abstracting from leading indicators in binary options brokers costs in both examples.

If we 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. For our LEAP-covered write, meanwhile, the position would show the same loss amount, since the delta on the LEAP mimics the long stock position when in the money. Since the January call has a strike price of 25, it is still in the money at However, should the stock fall lower, the advantage shifts to the LEAP strategy.

This is where it gets more interesting as an alternative strategy. Therefore, at a share price of 25 upon expiration of July Volatility Advantage There are other, not-so-obvious advantages to a LEAP-based strategy. 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. Therefore, the JPM volatility has a good chance of rising during the month period before the LEAP expires and even before the July call expiration date, helping us out on the downside.

Since implied volatility and stock prices have an inverse relationship, a drop of any sizable covered call and leaps a wealth option 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. Now our loss can be recalculated to incorporate the amount we would gain from a rise in this volatility.

If interest rates were to rise, netflix stock market 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. But there is one other significant advantage that is not all that apparent at first.

In the traditional covered call write, 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 removed. But the traditional covered call writer still has a lot of potential downside risk in holding JPM stock longer. Theoretically, the price could fall to zero, although that would be covered call and leaps a wealth option.

Now let's assume the traditional writer panics and sells his position when JPM breaks But then if the stock recovers six months later and rallies back to 40 by the time the LEAP expires js change select option textwe begin to see the beauty of the LEAP covered write strategy. This comparison does not address the kinds of rolling of the short calls or writing of additional short calls once July call expired.

Nevertheless, the example of JPM does illuminate some key advantages of LEAP covered writing offers. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund. Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin?

This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.

Using LEAPS In A Covered Call Write By John Summa Share. JPM Price July Call Strike Call Premium Maximum Profit Jan 25 LEAP Price July Covered calls may require more attention than bonds or mutual funds, but the payoffs can be worth the trouble.

The rewards of using LEAP call options can be a lower cost of capital, higher leverage and no risk of margin calls.

Using LEAPS In A Covered Call Write

Options are always speculative, but LEAPS provide a longer time frame, which may make them more profitable. Learn how to multiply returns and diversify risk by buying options instead of stock.

The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably. While writing a covered call option is less risky than writing a naked call option, the strategy is not entirely riskfree.

This different approach to the covered-call write offers less risk and greater potential profit. These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. Try this approach to covered calls to increase your potential for profit in any market.

A LEAP long-term equity anticipation security is a call or put option that allows the buyer a long-term expiration on the Learn how short calls are used in a covered call option strategy, what the risks and rewards of this strategy are, and how Learn about option strategies that investors can use with stocks in the automotive sector, including covered call strategies An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.

A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other.

A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation.

A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over No thanks, I prefer not making money.

Content Library Articles Terms Videos Guides Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator. Work With Investopedia About Us Advertise With Us Write For Us Contact Us Careers.

Get Free Newsletters Newsletters. All Rights Reserved Terms Of Use Privacy Policy. Table 2 — LEAP-Based Covered Call Write prices from close of trading December 16, Table 3 — Loss comparison if JPM falls to 25 we are assuming no time-value decay in this scenario.