Thursday, November 12th, 2009
A Better Alternative to Covered Calls
Free Special Report: Top Value Stocks for Q2 2010
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).
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Written by Simon Monger
