Rich Dad Education Blog

LEAPS Defined:

To preface our conversation of LEAPS covered writes, let us review the basic definition of LEAPS. LEAPS stands for Long-term Equity Antici Pation Securities. Investopedia defines LEAPS as follows: "Publicly traded options contracts with expiration dates that are longer than one year." It may be important to note there are some discrepancies as far as how much time is needed in an option for it to be considered a LEAPS. Other sources consider options with longer than six to eight months LEAPS options. For the sake of our conversation, we will consider any option with around eight months or more until expiration a LEAPS option. There is no structural difference between a LEAPS option and a short-term option other than the amount of time until expiration. Remember, options are a decaying asset; thus they lose value as time passes (an effect known as time decay). The effects of time decay increase as options approach expiration. Therefore, due to the amount of time one is buying, LEAPS options experience less time decay.

Structure:

The basic structure to the LEAPS covered write is to buy a LEAPS call option and simultaneously sell a short-term (two to six weeks) call option against it. The only major difference in the structure of a LEAPS covered write and a covered call is that instead of buying 100 shares of the stock, we buy a LEAPS call option. Similar to a covered call, we can sell short-term call options against our LEAPS option, generating monthly income.

Strike Price Bought:

In order to keep the risk/reward characteristics of a LEAPS covered write similar to a covered call, it is important to buy a deep in-the-money LEAPS. Buying a LEAPS with a delta greater than .80 should suffice.

Strike Price Sold:

In a traditional covered call, we would sell one strike out-of-the-money. Use the same approach with the LEAPS covered write. One other way to approach this decision is to sell the strike price at which you think the stock will reside at on the expiration date of the short-call option. For example, if I was really bullish, I may consider selling two strikes out-of-the-money. Just make sure you are bringing in enough premium on the out-of-the-money option to make it worthwhile.

Finding the Right Stock:

We use somewhat of the same approach finding a stock for a LEAPS covered write as we would for a covered call. Both strategies profit from a neutral-to-bullish move in the stock. Therefore, look for stocks moving sideways or in mildly bullish up trends. We would also want a stock exhibiting lower volatility. For example, a stock that has made wild up-and-down swings over the last few months may not be the best candidate. Anytime we are looking to do a longer-term trade, such as the LEAPS covered write, it makes sense to use fundamental analysis to assess the strength of the company to make sure we are comfortable holding it. This would include making sure the company has had good earnings growth in the past and high-growth potential for the future.

Other potential candidates for LEAPS covered writes include exchange traded funds (ETFs). These investment vehicles give us the ability to trade the major indexes and sectors, such as the S&P 500 (SPY), Dow Jones Industrial Average (DIA), and NASDAQ 100 (QQQQ). These are great trading vehicles offering very good liquidity and tight Bid/Ask spreads.

Comparison of a covered call vs. LEAPS Covered Write:

Let's assume stock XYZ is trading at $186 and the current date is June 2.

XYZ Covered Call

Buy 100 shares for $186 and sell a Jun 190 Call for $5.40
Max Reward = $940
Max Risk = $18,060
ROI = 5.2% ($9.40/$180.60)

XYZ LEAPS Covered Write

Buy (1) Jan 2009 140 LEAPS call for $55.90 (9 months to expiration and delta = 86)
Sell (1) Jun 2008 190 call for $5.40 (3 weeks to expiration and delta = 44)
Max Reward = $700
Max Risk = $5,050
ROI = 13.8% ($700/$5050)

In a side-by-side comparison it is easy to see how the LEAPS covered write provides a MUCH cheaper alternative to the covered call ($5,050 vs. $18,060). In addition, we also generate a higher ROI (13.8% vs. 5.2%).

Avoiding Assignment:

By selling a call option, we are obligating ourselves to sell the stock if it rises past the strike price of the short call. Anytime we are short on options, there is always the risk of being assigned. However, that risk dramatically increases as the short option gets deeper in-the-money and as we get closer to expiration. In a covered call, being assigned is not necessarily an issue because we own the stock and are able to sell it if we receive assignment. However, in a LEAPS covered write, we do not own the stock; therefore, it is wise to avoid assignment by buying back any short in-the-money options prior to expiration. If the short option is out-of-the-money at expiration, we simply let it expire worthless and then reassess the stock and determine whether or not we want to short the next month's option to continue the trade.

We could continue selling short-term options against our LEAPS option month-to-month. However, at some point, we will begin to run out of time on our LEAPS option. As the LEAPS option approaches expiration, we will also begin to experience more time decay. To avoid this increase in time decay, it is wise to exit our long LEAPS position around two to three months prior to expiration.

For those of you seeking a more comprehensive overview of this powerful strategy, the LEAPS covered write is taught in depth in our Advanced Covered Calls class.

Tyler Craig is a stock coach for Wealth Intelligence Academy®.