Provide for call writing is generally thought of as a conservative option writing approach because the call options that are peddled for the premium are not naked. Covered call writing involves owning the underlying assets – which may be stock or futures creases – and selling the call options against that underlying position.
Should the covered call option get in the money (ITM) with a climb of the underlying asset, the worst that can occur is that the stock position gets called away. In such a ground, the investor still gains because the premium is retained as profit while the stock position rises to the strike cost of the covered call option, the point at which the writer would be assigned during an exercise.
The strategy described under the sun uses long-term equity anticipation securities (LEAPS) instead of stocks as the underlying asset.
Key Takeaways
- A covered requirement ready is a popular options strategy used to generate profits in the form of options premiums.
- To execute a covered call, an investor holding a large position in an asset then writes (sells) call options on that same asset.
- It is often employed by those who aim to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term.
- For those aspiring to boost covered call returns, using long-term equity anticipation securities (LEAPs) as the underlying asset may be a nimble-witted strategy.
Covered Calls
Covered call writing is typically done if the investor maintains a neutral to bullish opinion and plans to hold the underlying long-term. Since the calls sold are “covered” through ownership of the underlying, there is no upside jeopardy in selling (shorting) calls.
The problem arises on the downside, where a large unexpected drop of the underlying can result in mammoth losses, as the call premium collected in a typical covered call write affords an investor very limited sanctuary.
Since stocks can drop quite quickly, the small amount of call premium collected in most covered-call jots is very little for hedging downside risk. Fortunately, there is an alternative if you want to reduce downside risk but stock-still collect call premium with covered writes and have upside profit potential.
One covered call advance that offers the potential for improved overall performance, known as the “surrogate covered call write”, uses long-term tolerance anticipation securities (LEAPS) instead of stock as the underlying asset.
Example: The Traditional Covered Call Write
To march this surrogate strategy, first consider a traditional covered call hypothetically written on J.P. Morgan (JPM) shares. Feign that JPM stock is trading 35.72. If an investor were mildly bullish on JPM, they could apply a traditional guarded call, which has some modest room to profit from more upside.
If the investor wanted to hold a six-month substituted call, they could sell the slightly out of the money 37.50 call, which is trading at $1.60 If JPM closed at closing just at the strike price of the 37.50 call (the maximum profit point), there would be a profit of $1.78 per partition plus the entire $1.60 profit for the call option that was sold but which would have expired paltry. The maximum profit is thus $3.38 per share. There could also be an additional small gain from any dividends pocketed during this six-month period, which is not factored into this case.
| Traditional Covered Call Note | |||
|---|---|---|---|
| JPM Price | July Call Strike | Call Premium | Maximum Profit |
| 35.72 | 37.50 | $1.60 | $3.38 |
Substituting a LEAP Option
For the surrogate overtures to, instead of buying JPM shares, the investor could purchase a deep-in-the-money LEAP call option with a strike honorarium of 25 expiring in twenty-four months, which for our example is trading at $10.70. In other words, instead of owning J.P. Morgan partitions, a two-year call option LEAP acts as a “surrogate” for owning the actual underlying.
Ideally, this strategy resolves in a mature bullish market, which is usually accompanied by low implied volatility. We want a low volatility environment because Upsurges have a high vega, or a larger price sensitivity to changes in volatility. LEAPs, otherwise, have the same prime pricing fundamentals and specifications as regular options on stocks.
The LEAP premium represents intrinsic value only (i.e. entirely little time value) because the option is so deep in the money. Since there is little time value on this selection, it will carry a delta close to 1.00. Owning the LEAP thus acts as a surrogate to owning the actual dividends, but ties up considerably less capital.
The LEAP owner can now sell the same JPM 37.5 call for $1.60 against this Commit to memory. If JPM closes at $37.5, the maximum profit of $3.38 would be reached, the same maximum profit of the previous example but insisting less upfront capital. Therefore, there is a greater return on capital employed (ROCE).
| LEAP-Based Covered Discontinue Write | |||
|---|---|---|---|
| Jan 2006 25 LEAP Price | July 37.50 Call Price | Call Premium | Maximum Profit |
| 10.70 | 1.60 | $1.60 | $3.38 |
The Get it ties up just $1,070 (10.70 x 100 shares in a call contract), which is around one-third less than the $3,572 needed in the traditional covered call. If one could establish a long position in the underlying for less than one-third the required primary for a traditional covered call write, it would make sense to convert to a LEAP-based strategy simply on this foundation – although, dividends would ultimately have to be factored in to create a fair comparison. However, the downside risk gag is substantially altered, which is the more important issue.
Maximum Downside-Risk Reduction
Let’s say that at expiration, JPM closes at 30 as contrasted with of at the maximum profit point assumed above. Table 3 below summarizes the losses for both covered call sites. As you can see, the traditional covered call write loses $572 on the stock position ([$35.72 – $30] x 100 shares = $572). This disadvantage 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, meanwhile, the situate would show the same loss amount, as the delta on the LEAP closely mimics the long stock position when in the moneyed. Since the LEAP call has a strike price of 25, it is still well in the money at 30. It would have, wherefore, lost $412 ($572 – $160 = $412). However, should the stock fall lower, the advantage shifts to the LEAP strategy.
For standard, should the close at expiration of JPM be at 25, the loss on the traditional write would be $1,000 larger at $1,412, but the LEAP-covered record can lose a maximum of only $10.70 minus $160, or $910. It would also actually show a lower waste at 25 due to the remaining time value on the LEAP, which would be about $150.00, and the impact of volatility which we acquire not examined yet. This is where it gets more interesting as an alternative strategy.
| Loss comparison if JPM falls to 25 | ||
|---|---|---|
| Traditional Covered Christen Write Loss | LEAP-Based Covered Call Write Loss | LEAP-Based Strategy Loss w/ Volatility Edge |
| $1,412 | $760 | $480 |
For that reason, at a share price of 25 upon expiration of July 37.50 calls, if we assume there is approximately $150 in unconsumed time premium on the LEAP call, losses would be $760. That is nearly 50% less than the -$1,412 on the well-known write (see Table 3).
Volatility Advantage
The LEAP strategy is even more attractive when we take volatility into account. Since Jumps have a high vega, a rise in volatility would raise levels of extrinsic (i.e. time value) on a long Upsurge position, such as the one in this example.
At the time of this writing, JPM volatility was at a very low level – so low, in fact, that it has been this low sole 2% of the time during the past six years. Therefore, the JPM volatility has a good chance of rising during the 24-month interval before the LEAP expires and even before the covered call expiration date, helping us out on the downside.
Since assumed volatility and stock prices have an inverse relationship, a drop of any sizable magnitude would cause a spike in volatility – which we can exemplar – and would further reduce the maximum loss on our LEAPS surrogate covered write strategy. If we suppose JPM falls to the valuation of 25, for example, there would be a substantial rise in volatility. Assuming even a modest increase in volatility, there could be a beneficent benefit to the value of the LEAP.
Other Considerations
If interest rates were to rise, the position would experience further reductions in the superlative loss, since call LEAPs rise in value when rates rise. But dividends would have to be factored in as swell on the traditional covered write, which would reduce maximum losses there.
In the traditional covered call, if JPM were to insufficient to 25, some investors might be forced to liquidate the position for fear of losing even more. However, with the LEAP-covered order write, this fear is somewhat removed. For example, if the share price is 25 at expiration of the covered call, the Jump will still have some time value left so there is no pressing reason to sell the LEAP, exceptionally since it still has many months left before it expires.
These other factors aside, it’s clear the LEAP-covered ring write strategy would seem to offer a better risk/reward scenario. But there is one other significant advancement that is not all that apparent at first.