Options Trading Strategy: Writing Covered Calls

For example, at the end of 2008, the Gilead Sciences (GILD) (2011) 50 LEAP Calls were selling for $14, and the near-term GILD Jan (2009) 52.50 Calls were at $2. Selling the Jan (2009) 52.50 Calls against the LEAP generated an immediate return that can be used toward purchasing the LEAPS.

If the shorter-term call expires out of the money, you can sell another short-term call against your LEAP. If you are able to duplicate your original call-write throughout the life of the LEAP, you would generate continual income against your $1,400 LEAP investment.

One word of warning: though you are using a LEAP as a surrogate stock, you are not really writing covered calls. The technical term for writing short-term options against long-term options is "calendar debit spread." The mechanics of exercise and assignment with a calendar spread are different than for a straight covered call. There is also more risk involved.

For example, if you bought 100 shares of GILD stock at $50 and were assigned the $52.50 covered call, you would simply sell the stock you already own at $50, for a 5% total return.

But when you buy a LEAP, you don't own the stock. You have only bought the right to own the stock.

In our example, you have bought the right to buy 100 shares of GILD at a price of $50. You have paid $1,400 for this right. If you are assigned the $52.50 call, you are required to sell 100 shares of GILD at $52.50. You could exercise your LEAP to buy the stock at $50, then sell it at $52.50. This is a 2.5-point gain, about the same amount you paid to buy the LEAP. So most of your profit would be the $250 you received for selling the covered call.

How to Eliminate Risk

To remove even more risk from this options trading strategy, you should only write covered calls that are above the breakeven stock price for the LEAP, unless the LEAP price has declined significantly and you are simply trying to reduce your loss.

Over the years we have been able to use this "buy LEAP, write covered calls" strategy to generate enough covered call income to actually lower the net cost of some of our LEAP recommendations to zero, while garnering price gains of more than 200%.

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