Thursday, November 12th, 2009
A Better Alternative to Covered Calls
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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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-- Written by Simon Monger
