Covered calls is an options trading strategy that involves writing a call option on a security owned by the investor.
The investor earns a premium on the option. The investor profits if the stock price stays below the call option's strike price.
The maximum loss he can incur is the cost of the security minus the premium earned. This strategy is considered a low-risk, neutral strategy.
When Should an Investor Consider Writing a Call Option?
A covered call strategy is good to implement when the underlying security is not expected to move much.
If the investor has a long position in a stock that he plans on holding for a while, he should write covered calls.
An important point to remember while writing a covered call is that the underlying security price should not move sharply.
What is LEAPS?
LEAPS stands for Long-Term Equity Anticipation Securities.
LEAPS are publicly traded options contracts with an expiration date ranging from more than a year to three years.
These can be either call options or put options and allow investors to speculate on the price of a security over a long period.
The premiums for LEAPS are greater than those for short-term contracts as, over the long term, the probability of a sharp price movement is higher.
What is LEAPS for Covered Calls?
Covered calls is considered a safer strategy and ideal if the market is expected to remain stable or even slightly bullish.
However, there is no protection from the downside risk, i.e. the risk incurred when the underlying security price goes down.
The small premium earned from the written call options is not enough to compensate for the tremendous losses that can arise if the stock prices drop drastically.
LEAPS can be used to mitigate this downside risk instead of owning the security.
The advantage of using a LEAPS strategy over the actual security is that much less initial capital is required for conducting the trade.
What are the Advantages of LEAPS?
LEAPS has various significant advantages, such as:
It is advantageous in a covered call because it requires a lower initial investment than owning the security and reduces the risk faced if the security price drops drastically.
In the LEAPS strategy, investors buy a long-term call option or a LEAPS with a strike price much lower than the stock's current trading price. They then sell a slightly higher-priced call option on the underlying security and earn a premium. If the security price rises above the strike price and the option is exercised, the investor can either exercise LEAPS or sell it to deliver the stock. If the price remains below the strike price, the maximum profit is the same as owning the stock.
Compared to covered calls, the LEAPS strategy significantly reduces downside risk. If the stock price decreases drastically, the maximum loss an investor can face is the premium he paid for the LEAPS, less the premium he earned from selling the call options. However, if the underlying stock was owned by the investor, he could face unlimited losses as the stock price could go down to zero.
To sum up, we can safely state that the LEAPS strategy reduces downside risk and offers a higher return on capital employed. Also, it achieves the same maximum profit as a covered call but requires a lower initial investment.