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Covered Call Alternatives. II

Part I

Looking at the strategy mentioned by Steve Smith in a Minyanville article:

As an improvement on writing covered calls, the suggestion is to:

  • Replace long stock with a LEAPS option

  • Instead of writing a call, sell a call spread

I'm using an example that is similar to (but with different strike prices) the covered call position Smith used. 

My bias is towards writing covered calls that are not OTM (I like the better downside protection that comes with writing calls with a lower strike price, even though this reduces the maximum possible profit) and chose to write a call that is closer to being ATM than Steve chose.  It does not alter the discussion.

I included risk reward graphs* generated by using the online software tool available from Interactive Brokers.  I am using last Friday's (10/30/2009) closing prices to generate these examples.

* You can call these risk graphs, P/L graphs, risk/reward graphs.  It doesn't matter what you call them – just use them.


First let's compare the covered call with the LEAPS version.  In Part III time we'll look at the idea of selling a call spread in place of a call.

Covered call:

  • Buy 100 shares of SPY @ $103.56
  • Sell (write) 1 SPY Jan 106 call @ $3.35
  • Net debit (excluding trading costs): $100.21  Corrected


2009-11-01_1249SPY_CC


LEAPS version.  I'm using the Dec 2011  90 calls. (I know Steve Smith used Jan 2011 calls, but I cannot verify that those options are listed for trading on any exchange).

  • Buy 1 SPY Dec '11  90 call @ $21.50
  • Sell (write) 1 SPY Jan 106 call @ $3.35
  • Net debit (excluding trading costs): $18.15


2009-11-01_1322LEAPS_cc2

As I've previously mentioned, the substitution of a long-term option for stock makes a big difference in the results.  The downside risk is cut substantially, as can be seen in the graphs.

But, the profits are also limited.  In fact, if SPY rises above 135 in this example, the position loses money.

Thus, using a LEAPS option as a stock substitute when writing covered calls is not as simple as it may seem.  It does make the downside better, but the proponents of this idea never talk about the potential upside problems.  I don't recommend using LEAPS as a stock replacement when writing covered calls.

***

There is special beauty in the strategy we are going to discuss.  I know it's taking me a long time to get to it, but my purpose is not just to discuss the strategy recommendation, but to write about the steps leading to it, allowing readers to have a better understanding of why the suggested strategy is good (or not so good, depending on your trading style and comfort zone).  Options for Rookies is a blog devoted to helping readers understand options.  It is not designed to show you a trading idea and tell you – "okay, now go ahead and trade." 

to be continued

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