Many people’s first experience of options trading is the covered call. It’s a relatively easy to understand extension to normal stock investing: buy stock and sell out of the money calls to boost ‘income’.
There are a few problems with the strategy though. As I’ve noted elsewhere its actually more risky than it seems; it has the same risk profile of a naked put sale. A significant fall in stock price hurts each equally.
The second issue is its cash requirement. Even on margin this strategy requires 50% of the stock price upfront. Monthly OTM call sales produce 1-2% in income; a good return but curtailed should the stock rise above any of the sold calls’ strike price (very likely to happen several times in a year).
The third is the nature of many seemingly eligible stocks. Many investors choose volatile stocks, especially tech stocks such as Apple (AAPL), Google (GOOG) etc, which they believe will rise in value over time. Unfortunately, although possibly true in the medium to long term, wild movements in stock prices make the positions tough to manage. Apple in particular can be very frustrating.
So can we tweak the covered call to remove, or at least mitigate these issues? Well yes we can: by using a deep in the money LEAP call on a ‘boring’ stock.
LEAPs (or Long-term Equity Anticipation Securities) are options with a strike price a long time in the future (6 to 18 months). By purchasing a deep in the money LEAP call we get (most of) the upside with much less capital. For example a purchase of 100 Google shares (approx. $690) would require about $34,500 in margin capital. A GOOG 600 March 2013 Call can be purchased for $110, a capital requirement of just $11,000.
The attraction of ITM LEAP calls is that they closely, but not precisely, track the stock price. Choosing LEAPs with a delta of over 75 ensures that most upside is captured. More subtly they provide a cushion against heavy falls; they have positive gamma and so they don’t fall as much as the stock as delta falls, and large positive vega causing the IV, and so option price, to rise on any sharp stock fall. This mitigates the ‘same as a naked put’ risk described above.
Finally a good, boring, stock can be chosen. We like Union Pacific Corp (UNP), which runs railroads in the central and western parts of the US. As can be seen on the below chart its had a steady rise, with minimal short term volatility, in the last year.
UNP is a classic example of a company with a strong moat; Buffett speak for a company which cannot be challenged easily due to some attribute, industry dynamic etc. The Union Pacific railway has an effective monopoly on west coast rail traffic (it’s actually a bit more complex but this will do for now); we don’t see anyone building a competing railroad, or breaking up UNP’s effective market power anytime soon.
Furthermore UNP tends to be a proxy for the US economy. If you, like me, are generally bullish about its prospects, the railroad business should do well.
- Buy 4 UNP 100 Jan14 Calls @ $29.55
- Sell 4 UNP 125 Oct12 Calls @ $3.20
- Total cost: $10,540
- Stock price: $129.94
- Strategy: Every month, until January 2014, near expiration:
- Sold call ITM: buy back sold call and sell call at same strike
- Sold call ATM/OTM: sold call expires, then sell first call OTM
The aim is to collect premium over the 18 month life of the Jan 14 LEAP so that the following is true in January 2014:
Premiums collected + Amount Jan14 calls are ITM > Initial Cost ($10,540)
Should, as we hope, the stock continue to rise it should easily satisfy this requirement. Only significant, and unusual given UNP’s history, volatility would threaten the above.
One negative I must mention: the differences in the above options’ IVs. The UNP 100 Jan14 Calls’ IV is 29% whereas the UNP 125 Oct12 Calls’ IV is 19%. It would normally be a bad idea buying high IV and selling low IV but here it doesn’t matter so much. The bought LEAP worth $29.55 contains only $4.61 of intrinsic value (ie time value) at the 29% IV; it would be approx. $2 if IV was 19% on this call too.
Therefore we are ‘overpaying’ by approx. $2.60. Is this a problem? Well it’s not good – but the effect of the $2.60 overpayment is dwarfed, I’d suggest, by the amount of premium to be collected over 18 months. Therefore the trade is still valid.
This is a low risk, high probability over time trade with a good return on a relatively low amount of capital.