| Selling LEAPS Covered Calls |
| The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.
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| The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.
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| Investors should be aware of the risks involved in a covered call strategy. Call writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price. The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.
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| The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS call. ZYX is currently trading at 39½, and a ZYX LEAPS call option with a two-year expiration and a strike price of 45 is trading at 3¼.
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| An investor owns 500 shares of ZYX at $39½ per share and sells five of ZYX LEAPS calls with a strike price of 45 at 3¼ each or a total of $1,625. The investor's objective is to obtain profits without selling the stock. The break-even point for this covered call strategy is 36¼ (the stock price of 39½ less the premium received of 3¼). This represents downside protection of 3¼ points. A loss will be incurred if ZYX declines to below 36¼. Possible outcomes of this strategy at expiration are as follows.
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| Stock above the strike price |
| If ZYX advances to 50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of 45 less the price of the stock when the option was sold plus the option premium received of 3¼ X 100).
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| Stock below the break-even point |
| If ZYX is trading at 34 at expiration, the unexercised LEAPS calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.
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| Stock between the strike price and the break-even point |
| If ZYX advances to 40 at expiration, the LEAPS calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of 3¼ per share.
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Although we have outlined for educational and informational purposes the basic options strategies that investors may find useful, this discussion is in no way complete. We encourage investors to fully understand the risks associated with options trading by thoroughly reading the Characteristics and Risks of Standardized Options and asking questions of your broker. For your information, please read this website's Disclaimer.
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