know your options: covered calls using LEAPS
Hello Mark -

Thank you for providing good and straightforward feedback to the many questions that you get.

I have one question that I hope you can help me with: Is there any reason NOT to use LEAPS in a covered call strategy? It seems to me that a conventional covered call
has more downside risk than writing a call with a LEAPS at a lower strike as the underlying.

What is your take on this?

Best Regards,

Hello Thomas,

I appreciate the kind words.

Your question is whether there's a reason NOT to use LEAPS.  Thus, I'll minimize the advantages of using LEAPS.

The answer is 'yes.'  There are two basic reasons.

True, the CC has more downside risk, but have you considered the upside?  When you write a covered call, you NEVER have a problem, no matter how far the stock rallies.  That's not true with LEAPS.  Because LEAPS are options and have time premium, once the stock rises above the strike price of the call you wrote, your position becomes becomes 'delta short' (because the short call eventually has a higher delta than the LEAPS option you own) and loses value as the rally continues.

That's the danger.  You can reduce the risk at any time by buying back the written call and writing a new call with a higher strike price and a more distant expiration date (that's referred to as 'rolling' the position). If you can do that without paying cash, you are still in good shape, but a continued rally can place your profits in jeopardy again.

If you are careful not to simply close your eyes and hope the rally ends, and if you are willing to reduce your exposure to this potential problem by closing the position for a profit (I know, it's less than you hoped to make) when the danger presents itself, then this can be a viable strategy.

There is one other problem with owning LEAPS. LEAPS options are 'vega rich.'  That means they are VERY sensitive to changes in implied volatilities (IV).  Under most scenarios, when stocks rise in price, the IV decreases.  That means your LEAPS option is not going to increase in value as much as you anticipated.  That adds to the problem described above.

To keep the discussion of IV simple, option prices frequently rise and fall regardless of the direction in which the underlying stock moves.  If you are familiar with VIX (The CBOE Volatility Index), you know that VIX often changes by significant amounts.  When it rises, the price of LEAPS options increase significantly.  If you own a LEAPS position, such an increase in prices may afford a good opportunity to close the position and take a profit that's larger than you anticipated.  But, the opposite is also true.  If you purchase LEAPS when the implied volatility is high (and thus, option prices are high), the LEAPS is going to be expensive.  A large drop in implied volatility takes a big chunk of value out of the option you own (and a much smaller bite out of the option you sold), resulting in a position with a loss.  You may try to regain that loss by continuing with your original LEAPS strategy, but you must know that owning LEAPS is a play on the future direction of impl
ied volatilities.

Bottom line:  This strategy is touted by some advisors and works better than covered call writing under specific conditions.  But the risk of a decrease in IV and the threat of a big increase in the price of the underlying asset makes this method more risky than it appears.  Although I prefer not using it, choosing an appropriate strategy is an individual decision.  You gain something and you lose something when you substitute LEAPS for stock.  If nervous about a market decline, the LEAPS strategy is much better.

Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options