LEAPS: Options for the Long Term - Part 7
...continued from Part 6.
SELLING COVERED CALLS USING LEAPS
Thecovered call, which is selling (writing) a call against stock, is awidely used conservative options strategy. This strategy is utilized toincrease the return on the underlying stock and to provide a limitedamount of downside protection.
The maximum profit from anout-of-the-money covered call is realized when the stock price, atexpiration, is at or above the strike price. The profit is equal to theappreciation in the stock price (the difference between the stock'soriginal purchase price and the strike price of the call) plus thepremium received from selling the call.
(NOTE: Investors should be aware of the risks involved in a covered call strategy.)
Thewriters cannot realize additional appreciation in the stock above thestrike price since they are obligated, upon assignment, to sell thestock at the call's strike price. The downside protection for the stockprovided by the sale of a call is equal to the premium received inselling the option. The covered call writer's position will begin tosuffer a loss if the stock price declines by an amount greater than thecall premium received.
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The following example illustrates acovered call strategy utilizing an out-of-the-money LEAPS call. ZYX iscurrently trading at 39½, and a ZYX LEAPS call option with a two-yearexpiration and a strike price of 45 is trading at 3¼.
Aninvestor owns 500 shares of ZYX at $39½ per share and sells five of ZYXLEAPS 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 thestock. The break-even point for this covered call strategy is 36¼ (thestock price of 39½ less the premium received of 3¼). This representsdownside protection of 3¼ points. A loss will be incurred if ZYXdeclines to below 36¼. Possible outcomes of this strategy at expirationare as follows.
STOCK ABOVE THE STRIKE PRICE
If ZYX advancesto 50 at expiration, the covered call writer, upon assignment, willobtain a net profit of $875 per contract (the exercise price of 45 lessthe price of the stock when the option was sold plus the option premiumreceived of 3¼ X 100).
STOCK BELOW THE BREAK-EVEN POINT
IfZYX is trading at 34 at expiration, the unexercised LEAPS calls wouldgenerally expire worthless and the unassigned covered call writer wouldhave a theoretical loss of $1,125 (a present theoretical loss of $2,750on the stock position less the $1,625 premium received). This investorwill incur additional losses in his/her stock position if ZYX continuesto decline in value.
STOCK BETWEEN THE STRIKE PRICE & THE BREAK-EVEN POINT
IfZYX advances to 40 at expiration, the LEAPS calls will beout-of-the-money. Therefore, the call writer will generally not beassigned and exercised, and will retain the 500 shares of ZYX and theoption premium of 3¼ per share.
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