Systematic Covered Writing

 . . . more than just covered calls . . .

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FREQUENTLY ASKED QUESTIONS

•     Instead of buying the stock, why not buy a LEAP option and use it to cover the call?

For those entering sophisticated 'watch the market daily' strategies . . . please note that the question here is 'why not buy the LEAP instead of buying the stock'?  The question is not . . . 'why not have a long and short option position'?  The answers, as I have come to learn . . . are completely different, but then . . . so are the questions.

In an effort to add 'reality' to the answer to this question, the covered writer is going to use SNDK (SanDisk Corporation) as the underlying stock in both a SysCW covered call and a covered LEAP discussion and comparison.  The date is May 29, 2006 and SNDK closed on May 26th at $59.64.

Keep in mind that the question is . . . why not cover a LEAP instead of a stock?  I realize that there are traders that establish short term covered LEAP positions where they analyze the Delta ratios such that they are in a trade a short time . . . say one or two weeks.  The problem is , this is option trading not covered call writing.  This is a completely different strategy and really should not even be compared to covered writing.  To do so would be no different that asking why not enter Bull Put Spreads instead of SysCW covered calls?  Having said that . . .

With the traditional Systematic Covered Writing Initial Position, 100 shares of stock would be purchased and a call option that satisfied the guidelines for a new position would be sold.  SNDK has contracts at $57.50 in October because of it's 2:1 stock split.  The Oct $57.50 call option (SWFJY) has a Bid price of $9.10 at this time. Please click to view the Initial Position Math Exercise for this hypothetical position.

The 'math' works in that this covered position would provide over 15% downside protection as well as a back to cash annualized return of over 15% if the call option is exercised. Some look at the premium as cash that reduces the per share cost of the underlying stock with the trade-off being the limited upside potential because the writer has agreed to sell the stock at a specified price on or before a specified date. These same strategists would refer to this as a 'risk', whereas the SysCW suggests that this is simply one of two acceptable outcomes of the Initial Position. (If the writer would be 'unhappy' with a back to cash annualized return of over 29%, then he or she should not be writing calls in the first place!)

Before continuing, the philosophy of  Systematic Covered Writing is not to look at the premium received as reducing the cost of the stock, but rather new cash that was generated because the stock is owned. The cost of the stock is the cost of the stock. The investment will always be the same. Investors are now required to report the proceeds from expired options during a given tax year regardless of whether the stock has been sold or not, so to look at the option as 'reducing the cost basis' is somewhat 'old school' thinking.

There are non-traditional ways to establish a covered position, such as the Covered LEAP strategy.  In this case, the investor would buy an in-the-money long-term call option (a LEAP) and then sell shorter term calls against the position. Rather than owning 100 shares of stock, the investor owns (temporarily) an option contract that is going to expire and when it does, there is a possibility that it will be worthless. The proposed advantage to this strategy is the lower cost of establishing the position. The LEAP option that would be purchased would always cost less than buying the underlying shares of stock, which means one could establish additional positions. A valid thought, but their is a 'dark side' to this strategy.

Today (May29, 2006), in looking at the 2008 LEAP options for SNDK, one could purchase the $50 LEAP for $20.20 (YSDAJ). As you can see, instead of investing $5,695 in the stock, the investor is only investing $2,021 in the LEAP, hence the ability to leverage funds and enter additional positions.  The writer would then sell a shorter term call against this LEAP holding.  The guidelines for this strategy are the strike price of the call option needs to be high enough to cover the cost of buying the stock and the cost of the LEAP that was purchased.  In this case $50 (the strike price) plus $20.20 (the cost of buying the LEAP) equals $70.20, and the closest strike price to that amount would be the $75 in say October. This option could currently be sold for $2.85.

The reason for the covered LEAP guidelines is the investor must protect the position from the call that he or she is selling from being exercised. If the owner of the call you SOLD, exercises their right to buy, you in turn must exercise your right to buy so that stock can be provided to satisfy your obligation. The cost for YOUR stock is going to be the strike price ($50), plus what you paid for the LEAP ($20.20).

Using the SysCW Position Tracker, this position would look like this:

The rational behind this strategy is the reduced amount invested in the long position (LEAP verses stock). To 'see' this benefit, let's assume that in October, both options are exercised, which is a possibility, but not a 'sure thing'. Here is the closed position information.

Wow!  Look at how much higher the return is with the covered LEAP strategy!  This is how 'they' try to sell this strategy.  Here is what 'they' do not point out.

•    In order for this gain to be achieved, the price of the underlying stock must appreciate from $59.64 to at least $75 between now and October.  That is an increase of 15.36%, which could happen, but then again, may not happen.
•   If the stock does not appreciate, the October call would simply expire with the writer keeping the $479 in premium.

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Follow up:  Today happens to be October 4, 2006.  SNDK closed today up $3.07 on the day to $56.38.  Note that it is highly unlikely that SNDK will hit $75 by the October expiration, which means the hypothetical gain indicated above will not occur! Please note when this discussion was originally created in May of 2006, the covered writer had no idea what the price of SNDK would be in October of 2006!

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Now go back to the SysCW covered position.  Let's do the same thing.  Let's assume the call is exercised.  The closed position would look like this:

Notice that the covered writer would have invested more ($5,965 instead of $2,021) to make potentially less ($694 instead of $763). Again, this is what the proponents of the covered LEAP or long-term option strategy point out as why it is 'better'.  Systematic Covered Writing on the other hand will point out: "Just exactly what has to happen in order for the covered stock position to generate the profit listed above.   The answer:

ABSOLUTELY NOTHING!

The price of the stock can stay right where it is.  It does not need to appreciate by over 15%, in fact the stock could actually call by $2.00 and the option would still be exercised and the back to cash profit generated. If the underlying stock must 'do something' in order for a strategy to work, then the strategy is part of the IF Investing group of strategies. IF this or that happens, the strategy will work.

Now some may say that the call against the LEAP does not need to be as high.  The problem with this thought process is the risk of being assigned early.

Can the Covered LEAP strategy work? Absolutely, and there are many that use it successfully.  The key observation should be that they are also assuming additional risk.  Systematic Covered Writing has a strategy that is used to increase the potential gains (and risk). The additional gains are achieved through the use of typical Initial Positions with the limited (controlled) purchase of the underlying stock 'on margin'.  The return almost doubles and the writer still has the advantage of minimal need for the underlying stock to appreciate.

The following is a continuation of a discussion that

took place in April of 2006 . .

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As a real, but hypothetical example, on April 18, 2006, a SNDK 2008 $55 LEAP could be purchased for $23.30.  The stock at that time was trading at $64.17.

The recommended way to set up a Covered LEAP position is to have the strike price of the option be high enough to cover the cost of the LEAP that was purchased.  In this case, $55 + $23.30 =  $78.30, which means the writer would need to sell at least an $80 call to enter the Covered LEAP position. At the market close on April 18, 2006, the October $80 call had a Bid price of $4.80.  Here is a look at what this covered LEAP position would look like:

(Note Commissions based on actual fees at Interactive Brokers.)

It is now May 29, 2006 and SNDK is now trading at $59.64.  The 2008 Jan $55 LEAP that could have been purchased for $23.30 in April, currently has a value of $17.60 (to sell). The Oct $80 LEAP has a value of $0.05 to buy.  Hopefully, the reader can 'see' that the October call is probably going to expire and the writer can sell another call at that time. Or, they could be proactive and use the Buy Back & Lower strategy in an attempt to generate additional cash over the same time period.

Herein lies the problem, in the covered writer's philosophy with the covered LEAP strategy. Unless this stock recovers significantly, which it can do, between now and 2008, it will be hard to come out just breaking even on this position.  That is because the investor chooses to buy a wasting asset, an asset that has a limited life span.  In a nut shell, there is a limited amount of time to not only make up the cost of the LEAP, but to generate a profit for the investor's trouble.  Can this happen . . . sure, but will it? 

It is this 'what if the stock falters' possibility that keeps the covered writer away from this strategy.  Yes, the writer that purchased the stock back on April 18, 2006, would have paid $64.17 for the stock, but this stock is not 'going away' in 2008.  The covered writer can write calls against it until the cows come home, regardless of it's value.

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Follow up:  Today happens to be October 4, 2006. Again, the price of SNDK is currently $56.38, so either one of the covered LEAP illustrations above will probably have the October calls expire.  Again, the covered writer did not 'set this up' as proof for Systematic Covered Writing, but it is interesting as an example to illustrate the dark side of the covered LEAP philosophy.

The actual math below will be updated with the 'real' values when the October calls expire, but for now, take a look at the two ways of investing based on the May 29th examples above.  First, the SysCW position as potentially recorded in the Position Tracker after the October expiration.

The actual value and or outcome will be updated in three weeks, but for now (at current prices) the Oct $57.50 call would expire and the covered writer would simply recover the position with the Apr $57.50 call.  Note that the writer would now have over 28% of the net investment as 'Cash-in-Hand', which is not bad considering the stock lost about $300 in value as of this moment in time (October 4, 2006).

Note that it is possible the option may need to be rolled.  After all, SNDK could easily move above the $57.50 October strike price, but as of today . . . this is what would take place.

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Now let's do the same exercise for the covered LEAP hypothetical position.

Those that advocate the covered LEAP strategy will point out how close the Cash-in-Hand percentages are for these two positions.  They would then go on to stress that you could enter twice as many positions . . . which supposedly is looked at as being an advantage. Yes, I am biased, but what do YOU think of the following observations:

♦   Yes, the percentage is about the same so far, but this is neither a disadvantage nor is it an advantage. You would need to establish more than three of the covered LEAP positions to have the same amount of cash as you do with the one Systematic Covered Writing position. ($1,718.00 verses $563.00)

♦   The covered LEAP position is backed by a 'wasting' asset. As of October 2006, an investor would have a maximum of 16 months to make up that $2,021.00 investment.  Keep in mind that in January of 2008, this LEAP could have a value of ZERO.

Once again . . . the covered writer will point out that the only way a covered LEAP is superior to a covered stock is if the underlying stock appreciates to the call strike price.  Otherwise, the covered LEAP is significantly more risky than the covered call, with the understanding that Systematic Covered Writers are committed to being long-term investors.

As of today, that '08 Jan $50 LEAP could be sold for $16.50.  Let's look a both positions if for some reason the investor had to close them TODAY.  The data below is based on closing prices October 4, 2006

CLOSING the LEAP Position

It does not take a very wise investor to see that if he or she needed to go back to cash TODAY, that the covered LEAP position established in May would end with a net loss of $97.00.

CLOSING the SysCW Position

Hopefully, you 'see' the difference.  Anyone that believes that a covered stock position has the same risk as a covered LEAP position simply has not 'done the math', or does not know how to do the math.  The data above, though hypothetical in nature, is REAL.  This is not a matter of one strategy being right and the other wrong, but rather a suggestion that a wise investor should know the possible outcomes before he or she just 'believes' what they are reading.

For the covered LEAP position . . . the investor may have to make up the entire cost of the LEAP ($2,021.00) just to 'break even'.  For the covered stock position . . . the writer will always own the stock and regardless of it's value, there will be option traders out there willing to pay the covered writer because he or she does indeed own something.

The Covered Writer

PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN SNDK STOCK OR ANY OTHER EQUITY.  THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED!

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The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.

These are the terms of use.  Why are they here?  Because the examples provided are real.  The transactions actually took place.  The dates are real, the positions are real.  Some transactions will have been executed on the day you receive the email.  What you are agreeing to, is the fact that in no way is it being suggesting that you can, or should, enter a similar position.  Why?  Because that would be providing investment advice and the Covered Writer is not authorized to do that.  There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice.  Therefore, you are agreeing that the preceding example was provide for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised: 07/15/07