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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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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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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