Selling covered LEAPS (Long Term Equity Anticipation Securities) is a popular way for stock market investors to generate income with their stock portfolios, without necessarily having to sell their stock.
Covered Leaps are very similar to covered calls. What sets leaps apart from regular options is primarily the length of time until they expire – a leap has a much longer time before it expires, vs. standard options you may already be trading. This gives the option seller the advantage of receiving more premium money up front when the option is sold, due to the relatively long time to expiration.
The way investors use covered LEAPS to make money is by selling a leap option contract, using stock already held in their trading account as collateral. If this sounds familiar, it is just like writing a covered call. Thats right, LEAPS represent 100 shares of stock, just like a regular call or put option. The main difference between a regular options contract and a LEAPS contract is the length of time to expiration.
There are several advantages that covered leaps have over normal stock covered calls. First, you receive a larger premium up front. This is due to the longer time to the option expiration date. Next, if you are executing a covered call strategy where you sell a new call contract against your stock when the old one expires, you will have lower trading commissions with LEAPS. Finally, with the longer time horizon associated with LEAPs, an individual investor has a longer time period to plan out with a known risk/reward factor.
LEAPS covered calls are much like other stock covered call options that investors can use to generate cash income in their stock brokerage accounts, but with one important difference. The difference is that LEAPS, or Long Term Equity AnticiPation Securities, have expiration dates longer than one year. An example might help to explain how to use LEAPS covered calls to your advantage.
First, if you are not familiar with options trading, a call option gives the buyer the right, but not the obligation, to buy a pre-determined quantity of an asset, usually a stock or commodity, at the specified price (strike price), on or before the expiration date of the option contract. A covered call option is just a standard call option where the seller is covering the contract with securities that are already owned in their brokerage account. LEAPS covered calls are standardized call option contracts with expiration dates over one year away, that are secured by the shares of stock that are already owned in the sellers trading account. Since each LEAP option contract represents 100 shares of stock, these covered options can only be sold (also known as writing a call option) based on full 100 share increments of the underlying stock that the option is being written against. For example, if an investor holds 200 shares of General Electric (GE) in their brokerage account, they would be able to write (or sell) 2 LEAPS covered calls.
The longer expiration dates that LEAPs possess give long term investors the ability to get exposure to long term price changes, with no need for a combination of shorter-term option contracts. Also, the premiums (price) for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying stock more time to make a large price move and for the investors to make a good profits. Conversely, for the investor writing LEAPS covered calls, they get a higher cash payment up front for taking on the risk that they may be called out of their stock over the longer time frame contained in the covered LEAP contract.
One other characteristic that an investor considering writing LEAPS covered calls should consider is that the price decay of a LEAP call option is much slower than an option with a much nearer term expiration date. For instance, if a call option with a strike price equal to the underlying stocks current price only has a month to expiration, and the underlying stock price stays flat, the price of the call option will decline to nothing over the final month of the contract. However, a leap contract will register a very minimal reduction in price over the same month, due to it’s longer time to expiration.