Covered calls are a great strategy for reducing account volatility and earning income against your long stock positions.?And?long-term equity anticipation securities, or LEAPs, are a way to “lease” stocks for less money than it costs to acquire the stock outright.
Is there a way to combine the benefits of these two investing strategies to get the best of both worlds? Yes there is — by selling covered calls against a long LEAP option position.
This series of articles will focus?on covered calls on LEAPs, aka diagonal spreads strategy. If you have a basic understanding of covered calls and LEAPs, this should be something you will be interested in.
In this first part of the series, we will start the discussion about covered calls on LEAPs by looking at the risk profile of the trade compared to its potential benefits. Covered calls on LEAPs have distinct advantages, but understanding the risks is important as well.
Here are a few of the key concepts to keep in mind when trading covered calls on a LEAPs:
1. You are short a call without an underlying stock position. This means that if you are “called out,” you will find yourself short the stock.
2. A LEAP option has time value that is melting each day as you near expiration.
3. Option trades are often at a higher commission rate, and this will increase your trading costs.
The benefits of trading a covered calls on LEAPs are significant, and I?will outline a few of those in the list below:
1. The LEAP contract is cheaper than the underlying stock, and that increases your leverage and potential return on investment (ROI).
2. Because the LEAP contract is cheaper, you have less risk in absolute dollar terms than if you were holding the underlying stock.
3. This is a strategy that can be used with index options as well as stocks and ETFs.
4. Using it on index options with European-style expiration eliminates the possibility of early ex! ercise o f the short call.
Balance the risks and benefits to decide whether this strategy works for you and to help you decide the best way to implement it within your portfolio.
In?this series of articles, I will use a case study to illustrate the concepts. Repeat the steps in the case study on an option of your choice in a paper trade. Repeating the method yourself will help you understand the strategy and remember how it works.
Go on to Part 2.
This article originally appeared on the Learning Markets Web site.