An all-options covered write

January 22, 2016 09:00 AM

It is possible, and sometimes preferable to put on a covered write without an underlying stock. 

This strategy also is known as a leveraged covered call and back on the old trading floor we used to call it a Fig Leaf.

Here’s how it works. 

The idea is based on a covered write but using long-term options (two or more years duration), known as Long term Equity Appreciation Strategies (LEAPS) as a stock substitute. You own an in-the-money LEAPS call and sell a two- or three-month out-of-the-money call against it. The profit/loss graph of the strategy looks like this: 

Notice that the profit and loss lines are not straight. That’s because the LEAPS call is still open when the shorter-term call expires. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date.

You want the LEAPS call to track the movement of the stock, so you want to choose an option with a Delta of around 80, which is about 20% in-the-money. If the stock is particularly volatile you want to choose an option even deeper in-the-money.

The advantage of this strategy compared to a conventional covered write is that you don’t have to commit as much capital. Of course, you are long an option and not the stock, so you do not collect any dividends along the way.

Another hazard is if your short-term call expires in-the-money and you are assigned. You don’t want to exercise your LEAPS early because of all the time value you would be throwing away. And you probably don’t want the strategy to turn into long call/short stock because then you have a synthetic long put. If the short leg looks to expire in-the-money it is best to unwind the whole position, which, because your long leg is deeper in-the-money than your short leg, you should be able to do for a profit.

It’s basically a neutral-bullish strategy. Ideally, you want your short leg to expire worthless then sell a new short leg and keep doing that, collecting that expired premium, until you have the LEAPS for free.

Your worst case scenario is that the stock goes dramatically lower, so whatever premium you collect does not make up for your loss on the LEAPS.

Let’s look at a real-life example using Apple (AAPL).

Please remember that this example is date and time specific and cannot be replicated exactly. This is meant to show a way of thinking about this strategy. It is particularly attractive with a higher priced stock because of the more efficient use of capital.

Apple at the time of this writing is trading at 118. The January LEAP, which expires in January 2017 with a strike price of 95 (approximately 20% in-the-money), can be purchased for 28, or $2,800 per contract. We’ll call that strike B. Against that we’ll write, or sell, the January 2016 call with a strike price of 125 for 1.50.

With Apple below 125 on the January 2016 expiration, the short call expires worthless at the effective price of 26.50. We then sell the February, and so it goes.

With Apple above 125 on expiration it is advisable to unwind the position for the aforementioned reasons.

While covered writes in general are synthetic short puts, if covered writes are your thing, in my view it’s better all options than options plus stock.

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.