Covered Leaps

Selling covered LEAPS (Long Term Equity Anticipation Securities) is a popular way for stock market investors to generate income with their stock portfolios, without necessarily having to sell their stock.

Covered Leaps are very similar to covered calls.  What sets leaps apart from regular options is primarily the length of time until they expire – a leap has a much longer time before it expires, vs. standard options you may already be trading.  This gives the option seller the advantage of receiving more premium money up front when the option is sold, due to the relatively long time to expiration.

The way investors use covered LEAPS  to make money is by selling a leap option contract, using stock already held in their trading account as collateral.  If this sounds familiar, it is just like writing a covered call.  Thats right, LEAPS represent 100 shares of stock, just like a regular call or put option.  The main difference between a regular options contract and a LEAPS contract is the length of time to expiration. 

There are several advantages that covered leaps have over normal stock covered calls.  First, you receive a larger premium up front.  This is due to the longer time to the option expiration date.  Next, if you are executing a covered call strategy where you sell a new call contract against your stock when the old one expires, you will have lower trading commissions with LEAPS.  Finally, with the longer time horizon associated with LEAPs, an individual investor has a longer time period to plan out with a known risk/reward factor.

As you can see, covered LEAPS are as easy to use as regular options, and can provide you with several advantages when using them in a covered call strategy.  You should consider using them in your covered call writing strategy.

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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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