LEAPS Covered Calls

LEAPS covered calls are much like other stock covered call options that investors can use to generate cash income in their stock brokerage accounts, but with one important difference.  The difference is that LEAPS, or Long Term Equity AnticiPation Securities, have expiration dates longer than one year.  An example might help to explain how to use LEAPS covered calls to your advantage.

First, if you are not familiar with options trading, a call option gives the buyer the right, but not the obligation, to buy a pre-determined quantity of an asset, usually a stock or commodity, at the specified price (strike price), on or before the expiration date of the option contract.  A covered call  option is just a standard call option where the seller is covering the contract with securities that are already owned in their brokerage account.  LEAPS covered calls are standardized call option contracts with expiration dates over one year away, that are secured by the shares of stock that are already owned in the sellers trading account.  Since each LEAP option contract represents 100 shares of stock, these covered options can only be sold (also known as writing a call option) based on full 100 share increments of the underlying stock that the option is being written against.  For example, if an investor holds 200 shares of General Electric (GE) in their brokerage account, they would be able to write (or sell) 2 LEAPS covered calls.

The longer expiration dates that LEAPs possess give long term investors the ability to get exposure to long term price changes, with no need for a combination of shorter-term option contracts. Also, the premiums (price) for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying stock more time to make a large price move and for the investors to make a good profits.  Conversely, for the investor writing LEAPS covered calls, they get a higher cash payment up front for taking on the risk that they may be called out of their stock over the longer time frame contained in the covered LEAP contract.

One other characteristic that an investor considering writing LEAPS covered calls should consider is that the price decay of a LEAP call option is much slower than an option with a much nearer term expiration date.  For instance, if a call option with a strike price  equal to the underlying stocks current price only has a month to expiration, and the underlying stock price stays flat, the price of the call option will decline to nothing over the final month of the contract.  However, a leap contract will register a very minimal reduction in price over the same month, due to it’s longer time to expiration.

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Stock covered calls are a technique use by stock market investors to generate additional income from stocks that they already own in their investment portfolios.  While options trading may sound scary, this technique for generating income is actually so conservative that most brokers will even let you utilize this technique in your online Individual Retirement Account (IRA).

A call option gives the buyer the right to buy a pre-determined quantity of an asset, usually a stock or commodity, at a specified price (strike price), on or before the expiration date of the option contract.  A covered call option is a standard call option that the seller is covering with securities that are already owned in his trading account.  Stock covered calls are merely standardized call options that are secured by the shares of stock that are already owned in the sellers trading account.  Since each option contract represents 100 shares of stock, these covered option calls can only be sold (also known as writing a call option) based on full 100 share increments of the underlying stock that the option is being written against.  For example, if an investor holds 670 shares of Cisco Systems (CSCO) in their account, they would be able to write (or sell) 6 stock covered calls.

Now that we’ve gone over what stock covered calls are, lets look at how to use them.  Lets continue with the example of the investor with 670 shares of CSCO in their stock market investing account.  Since CSCO does not pay a dividend, and the investor wants income without having to sell his stock, he decides to sell call options that will expire in two months, for a price that is above todays stock price for CSCO.  In return for this option, the investor gets $1 per share, or $100 per covered option calls contract, times 6 contracts equals $600.  This cash is deposited directly into the investors trading account, and can be used for whatever purpose the investor chooses.  The investor is now obligated to sell the contract holder 600 shares of stock at the price specified in the contract, on or before the expiration date of the contract. 

Now if the stock price does not go above the contract strike price, the investor who sold the option contracts keeps his stock, and the cash he got from selling the stock covered calls, and can do it all over again on the trading day after the contract expires.  This is a very powerful concept, since it means that the investor can generate income multiple times per year by selling these call options. 

If the stock closes above the price specified in the contract, usually around the date the contract expires, the contract will be exercised by the option holder, and the investor will have to sell him the 600 shares of CSCO at the price specified in the option contract.  Since the contract price is above the price that the stock was trading at when the options were sold, the investor gets that capital gain profit, plus the cash that he was paid for selling the options.

While stock covered calls may seem a little complicated at first, in the end they provide you with a relatively easy way to generate cash flow on stocks that would otherwise just be sitting in your investment account.

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Covered option calls are a popular way to generate recurring investment income in an investment portfolio, even in retirement portfolios like Individual Retirement Accounts (IRA’s).  This income can be generated on any stock in your portfolio that has actively traded options associated with it, the caveat being that you need to own at least 100 shares of the stock you are going to sell covered option calls against in order to take advantage of this money making strategy.

Let’s start by looking at what a call option is.  A call option contract gives the buyer the right, but not the obligation, to buy 100 shares of stock at the price defined in the contract (strike price), on or before the date the contract expires (expiration date).  One of the key concepts here is that the buyer of the covered option call contract would lose money if they exercised their right to buy the stock, if the stock is trading below the strike price of the contract.  This is simply because they could buy the stock for a lower price on the open market, so there would be no point in exercising the call option contract under these circumstances.

In order to implement this income producing strategy, an investor will have to do a couple of simple tasks.  First, the investor would have to ask their broker to set up their trading account to allow options trading.  This usually involves reading a short pamphlet on the risks associated with standardized options trading, and signing a form indicating that you understand the risks.  The investor will probably also have to tell the broker what options trades they want to be approved for, and their risk tolerance for these types of trades.  As I indicated earlier, this strategy is so conservative, most stock brokers will even let you do it in your IRA account.

Next, the investor must identify which stocks they would like to sell options against.  These stocks can have options sold against them in 100 share multiples, since each contract represents 100 shares.  For example, if you own 230 shares of Apple (AAPL) in your account, you could write 2 covered option calls contracts against 200 shares of the Apple computer stock in your account.  Finally, the investor needs to determine what price they would be like to write the contract for, and how long they would like the contract to be in place.

Once the investor has completed these steps, they merely need to call their broker (or login to their online trading account), and place the order to sell the covered option calls from their account.  Once the sale is complete, the investor will receive cash in their account for the call options that they sold – this cash is theirs to keep.

If, at the end of the contract period, the price of the stock is below the call option strike price, then the investor keeps their stock, and can write new covered option calls against their shares of stock.  However, if the stock price has risen above the strike price of the option contract, then the investor will have to sell his shares to the contract holder at the strike price specified in the agreement.

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A call option is a useful tool for stock market investors to master.  First I will go over what a call option is, then descrcibe why it is a valuable tool for stock investors.  Just a note – I am going to describe standard options contracts that are traded in the United States.

Call option definition – an option contract that gives the current holder the right, but not the obligation, to buy 100 shares of stock in a specific company, at certain price (the options strike price), by a specific date (the expiration date).  Conversely, the seller of the option contract is obligated to sell 100 shares of the specified company to the holder of the contract, for the strike price of the contract, if the contract holder exercises his right to buy the stock on or before the expiration date.  This explanation probably needs an explanation to make the principal clear.

Lets say an investor holds 100 shares of General Electric (GE) in his trading account.  The dividend was cut, so the investor decides to sell a covered call option to generate some income, using his 100 shares of GE as collateral to “cover” the transaction.  The investor notes that the price of GE is currently $15, and the investor thinks it will probably stay under $20 over the next two months, so he sells a $20 call option, with an expiration date that is two months out, and he receives $1 per share ($100 total) in cash for the option contract.  At this point, the investor with the GE shares in his account is obligated to sell whoever is holding the call contract his 100 shares of GE stock for a price of $20 per share, until the contract expires.

So we’ve looked at why someone would sell covered option calls contracts – because they want the income, and do not believe the stock price will go above the strike price of the contract, but why would someone buy the GE call option contract?  Because they believe the stock may experience an upward move in price, and by utilizing only $1oo, they actually control 100 shares of GE stock, and can profit on any move over the strike price.  For instance, if GE went up to $25, the contract holder could call away the stock from the contract seller for $20 per share, and immediately turn around and sell the stock for $25, locking in a nice 400% profit in a period of two months.

As you can see, a call option can generate income for the person who sells the contract, as well as occasionally being a lucrative investment for the person who buys the contract.

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Covered Call

A popular strategy amongst investors looking to generate extra income from their portfolios is to sell a covered call option on stock that they already own in their investment portfolio.  Selling covered calls can be a good way to generate regular income on stocks that do not even pay dividends (but you can use this income producing strategy on dividend stocks too).

First, lets look at how this strategy works.  In this example, you own 100 shares of XYZ company in your investment account, it pays no dividend, and while you expect it to increase in price over time, it isn’t gaining in price very quickly, so you’d like to generate income with the stock until it hits your target sell price.  To do this, you sell a covered call option contract against your 100 XYZ shares (your 100 shares “cover” the contract as collateral).  In this scenario, somebody pays you cash that goes into your investment account, and no matter what happens next, the cash is yours to keep.  The terms of the contract are very simple – you promise to sell your 100 shares of XYZ to the person who holds the contract at the price specified in the contract, by the date the contract expires – this last term is very important. 

To continue our example, lets say XYZ company is currently selling for $20 per share, and you sell a call option using your 100 shares of XYZ stock as collateral with a strike price of $25, and a contract expiration date two months from now.  You receive $1 per share for your covered call contract, or $100 total, which is deposited into your investment account.  As long as the stock is less than $25 over the next two months, you will keep your stock, and the $100 you got for selling the contract.  In this case, you will be able to to do the same thing again after two months, up to six times per year.  In this example, you would be able to generate up to $600 in option income over the course of a year, from a stock that was just sitting in your online trading account.

What if the stock had risen above $25?  In this case, you would most likely have to sell your stock to the covered option calls contract holder (this is done automatically by your online broker), for $25.  So in this case, you would get the $25 per share for your stock, plus the original $1 per share that you kept from the sale of your option contract, for a total of $26 per share (or $6 per share gain from your $20 starting price) – not a bad profit for two months of risk in the stock market.

In order to execute this strategy, you will need to sign up with your stock broker to trade options in your account.  This strategy is so so conservative, that many brokers actually allow you to sell covered call contracts in your retirement IRA account.

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Stock Options Basics

Put options give an option buyer the right to sell 100 shares of an underlying stock at the strike price that the option contract was written for. While the put option buyer is not obligated to exercise the contract, if the buyer does exercise the contract, the option seller is obligated to pay the contract price for 100 shares of the underlying stock from the contract buyer, on or before the expiration date of the contract. Put option buyers are betting that the price of the underlying stock will move down. A put option becomes more valuable when the price of the underlying stock goes down.

are one of the most versatile trading vehicles available. Options on stocks are highly leveraged derivative investments, with a very well defined risk/reward profile.

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