Get on track with a Union Pacific LEAP ‘covered call’

Posted By on Sep 13, 2012


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.

 The trade

We will:

  • 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.

Any negatives?

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.

Conclusion

This is a low risk, high probability over time trade with a good return on a relatively low amount of capital.

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6 Comments

  1. A quick question, when is the ideal time for buying LEAPs, when the underlying stock is adready advanced or after any dips, if it’s already advanced, the chances are the underlying stock will be coming down and as it coming down we sell the upcoming month or when we buy it after any dip and the underlying rises and we sell the next month ?
    thanks.

    Post a Reply
    • I am usually quite skeptical about the ability to time entry in this way. But if you are a practitioner of technical analysis you can use the same rules as for short term stock trading ( buy at a support level, or on a pull back etc).

      Personally I have never manage to perfect this and so tend to ignore such things. I put on the trade if it makes sense at the current stock price; rathe than trying to wait for a even better time.

      Sorry I can’t be of more help…

      Chris

      Post a Reply
  2. Chris – I am in this trade and also your IBM trade with small amounts as I learn. I new to this type of trade and love the idea of “accumulating time decay” as you put it. These 2 trades appear to be similar except in UNP you are selling short terms calls against a longer term call that is substituting for owning the stock. In the IBM trade you are selling short-terms puts against a longer-term put. My question is 1) are these really as similar as they seem and 2) why choose calls over puts or vice-versa in any given situation?

    It seems to me as a beginning options investor, that I’d prefer to stick to one or the other technique as in mixing them up, I run the risk of making too many mistakes as each has a different ‘perspective’ for evaluating the position. Appreciate any insight.

    - Martin

    Post a Reply
    • Great questions, thanks.

      The short answer is yes they re similar but I decided to do trades that could both be done either the LEAPs way or the put selling way to illustrate the two key long term trades to everyone. I like to have a portfolio of both types to hedge market risk: if he market falls at least my short calls can be easily managed; if it rises then the puts are ok.

      As for whether to use one or the other very similar methods, and why to chose one over the other, I need to think a little more and will defer the question to a longer post if that’s ok with you.

      I’ll also think whether beginners should concentrate on one method (and which one).

      Keep the good questions coming.

      Chris

      Post a Reply
  3. why not consider both sides by adding in long ITM LEAP Put and selling to make premium throughout the year?

    Post a Reply
    • That’s a good idea but I tend to mix and match these methods at a portfolio level rather than on each stock.

      I’m putting together a post to discuss the various options for these two types of trades – and to answer questions such as yours – over the next few days. Hope you dont mind waiting until then for me to answer your properly.

      In the meantime thanks for the question.

      Chris

      Post a Reply

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