A Better Covered Call Alternative

Covered calls are perhaps the most popular options strategy for many investors. The strategy involves writing call options against an existing stock position in order to collect the premium. The investor collects the premium if the shares end lower than the strike price or gives up their existing stock at the strike price if shares are trading higher.

Essentially, covered calls can enable investors to agree to sell at a certain price and collect a “dividend” in the meantime. Unfortunately, many investors are just not satisfied with the returns available on many covered call plays as the market has become quite saturated. Luckily, LEAPS can help to create a new alternative to covered calls that are still relatively undiscovered!

Calculating Covered Call Returns

There are two types of returns that are often used to evaluate covered calls: the static return and the if-called return. The first one calculates the return if the stock price remains the same and the second calculates the return if shares trade above the strike price. Both of these are useful for evaluating the profitability of any covered call play.

The static return can be calculated by dividing the option’s premium by the stock price minus the option’s premium. The result is a percentage that reflects the yield assuming that the stock price doesn’t change. For example, assuming an option premium of $1.25 and a stock price of $10 per share:

$1.25 / $50 - $1.25 = 2.5%

The if-called return is slightly more complicated. The numerator is calculated by adding the option premium to the appreciation of the stock from the purchase price. This is divided by the purchase price minus the option’s premium. For example, assuming the same information as above and a current price of $55:

$1.25 + ($55 - $50) / $50 - $1.25 = 12.6%

In order to gauge true return, it is best to annualize these numbers. So, the static return in the above example would be 15.2% while the if-called return would be 76.6%. These are not bad returns, but some investors are not content committing so much capital to these returns. Luckily, there are many alternatives that investors can explore…

Diagonal Spreads as a Covered Call Alternative

Investors looking to improve their covered call returns can substitute LEAPS for the underlying stock ownership in a covered call position. The result is known as a diagonal spread, since the underlying is now an option instead of actual stock (and therefore not “covered”). Diagonal spreads can help greatly enhance returns, but differ greatly from covered calls.

The LEAPS diagonal spread generally returns the lowest dollar profit, but highest percentage returns. The reason is simply because the initial investment is so much lower for the same premium that comes as a result. However, it is important to remember that this also means a higher degree of risk under certain conditions.

Unlike traditional covered calls, diagonal spreads can suffer if the share price surpasses the strike and the shares get called away. The reason is simply because it costs money to exercise the LEAPS and they will also be paying any remaining time premium on top. The problem isn’t so much the magnitude of losses, but rather the complexity of the whole situation.

Diagonal spreads also lose money when the stock price goes down and the value of the LEAPS can even hit zero, which is very unlikely for stocks. However, LEAPS are still safer than buying on margin since they can better handle fluctuations (without worrying about margin calls) and have a set cost (the premium paid).

The fact is that diagonal spreads are most profitable when the stock remains in a tight trading range, but this is not a realistic expectation over the long-term. As a result, investors must be ready to track and follow-up on the diagonal spread in order to ensure that the position remains profitable…

Executing the Trade

One of the first questions that comes to mind for many investors is: How do I choose a strike price for the LEAPS? The key is finding a balance between the capital required to establish the position and the amount of time premium purchased. The book Understanding LEAPS recommends purchasing LEAPS 25 to 30 percent in the money for stocks with average volatility.

The next step is purchasing an out-of-the-money call option to write at the next expiration date. Options further out-of-the-money are safer but involve less of a premium. Remember that any follow-up action will end up complicating the situation and should be avoided. As a result, it is often wise to error to the high end when it comes to selecting a stock price.

Monitoring and Follow-Up

Diagonal spread traders have two courses of action if shares trade above the strike at or near expiration: Unwind the position or roll the roll the call to another expiration or strike price. Unwinding the position involves covering the short call and selling the long LEAPS and should be done if your opinion of the stock has changed substantially and the strategy no longer makes sense.

If shares are north of the strike price, but not dramatically higher, then it may be possible to roll to different strike prices or expiration dates. Rolling up a position means buying back the existing written call and selling another one with a higher strike price. Meanwhile, rolling out entails buying back the existing written call and selling another one further out into the future.

The decision to roll up or roll out depends largely on the situation. Rolling up will involve committing additional capital to the position while rolling out means you are skipping over one or more expirations in order to avoid committing more capital. The correct decision depends on the investors’ sentiment regarding the stock as well as any personal capital restraints.

Conclusions

Diagonal spreads can help covered call investors leverage up their returns without the use of margin. It is important to remember, however, that diagonal spreads differ in many ways from covered calls. As a result, they must be closely monitored in order to minimize the possibility of being assigned on the short call position as this can greatly complicate the situation.

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