Fig Leaf - Leveraged Covered Call

Published August 29, 2011

| TradeKing

THE STRATEGY

Buying the LEAPS call gives you the right to buy the stock at strike A. Selling the call at strike B obligates you to sell the stock at that strike price if you’re assigned.

This strategy acts like a covered call but uses the LEAPS call as a surrogate for owning the stock. Though the two plays are similar, managing options with two different expiration dates makes a leveraged covered call a little trickier to run than a regular covered call.

The goal here is to purchase a LEAPS call that will see price changes similar to the stock. So look for a call with a delta of .80 or more. As a starting point, when searching for an appropriate delta, check options that are at least 20% in-the-money. But for a particularly volatile stock, you may need to go deeper in-the-money to find the delta you’re looking for.

Some investors favor this strategy over a covered call because you don’t have to put up all the capital to buy the stock. That means the premium you receive for selling the call will represent a higher percentage of your initial investment than if you bought the stock outright. In other words, the potential return is leveraged.

Of course, there are additional risks to keep in mind as well: LEAPS, unlike stock, eventually expire. And when they do, it’s possible that you could lose the entire value of your initial investment.

Unlike a covered call (where you typically wouldn’t mind being assigned on the short option), when running a fig leaf you don’t want to be assigned on the short call because you don’t actually own the stock yet. You only own the right to buy the stock at strike A.

You wouldn’t want to exercise the long LEAPS call to buy the stock because of all the time value you’d give up. Instead, you hope your short call will expire out-of-the-money so you can sell another, and then another, and then another until the long LEAPS call expires.

THE SET UP

•    Buy an in-the-money LEAPS call, strike price A
•   Sell an out-of-the-money short-term call, strike price B 
•   Generally, the stock price will be closer to strike B than strike A

NOTE: Typically, the LEAPS call will be one to two years from expiration, and the short-term call will be 30 to 45 days from expiration.

WHO SHOULD RUN IT

• Veterans and higher

WHEN TO RUN IT

You’re mildly bullish

BREAK-EVEN AT EXPIRATION

It is possible to approximate break-even points, but there are too many variables to give an exact formula.

Because there are two expiration dates for the options in a fig leaf, a pricing model must be used to “guesstimate” what the value of the back-month call will be when the front-month call expires. TradeKing’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.

THE SWEET SPOT

You want the stock to remain as close to the strike price of the short option as possible at expiration, without going above it.

MAXIMUM POTENTIAL PROFIT

Potential profit is limited to the premium received for sale of the front-month call plus the performance of the LEAPS call.

NOTE: You can’t precisely calculate potential profit at initiation of this strategy, because it depends on how the LEAPS call performs and the premium received for the sale of additional short-term calls (if any) at later dates. Maximum Potential Loss

MAXIMUM POTENTIAL LOSS

Potential risk is limited to the debit paid to establish the strategy.

NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on how the LEAPS call performs and the premium received for the sale of additional short-term calls (if any) at later dates. 

AS TIME GOES BY

Time decay is your friend, because the front-month option(s) you sell will lose their value faster than the back-month long LEAPS call.

IMPLIED VOLATILITY

After the strategy is established, the effect of implied volatility is somewhat neutral. Although it will increase the value of the call you sold (bad) it will also increase the value of the LEAPS call you bought (good).

ABOUT THE NAME

Although this strategy has been run for quite some time, we at TradeKing have never heard an “official” name for it before. So we decided to give it one.

Special thanks to Weird Uncle Jesse from the TradeKing Trader Network for suggesting “fig leaf” (implying you’re kind of covered).

Props also go to TheMechanic and MLTrader for simultaneously suggesting “leveraged covered call” (which is a technically appropriate title).

POWERED BY

Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.

TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products.

URL

http://www.foxbusiness.com/investing/2011/08/29/fig-leaf-leveraged-covered-call/