While this strategy can leave the investor slightly unprotected against the downside (or upside) depending on how the strategy is used, it can provide returns that are less volatile and will outperform in a flat or falling market. The idea here is to expand on a typical covered call trading, holding long shares and selling calls against that position (1 call for every 100 shares). This strategy is suggested to be used with index funds that follow the broad market indexes, to avoid individual firm risk. Lets take a look at how this strategy can be used.
Portfolio 1 - All Stock
SPY - $101,346- 700 shares
Portfolio 2 - Using LEAPS
7 SPY December 2008 $120 Call - Total Cost: $23,310
$78,036 in cash
While purchasing the call option does entail an additional cost because of the premium, which is $8.49 per share, or a 5.9% premium to the current price, it does allow us to gain a full allocation to the index with about a 5th of the actual cost.
We then will look to sell covered call against our positions, which would mean that we will be selling 7 out of the money call options. For the position we will be looking at selling 7 $147 March 2007 Call options currently trading at $1.00. By taking this position we will be receiving $700 in premiums. We will assume that we will be able to receive a similar premium on the sold options every two months, so we will be receiving an approximate $4,200 a year or $8,400 for the two years that you hold the position. This would mean that for the approximate $100,000 position, you will be receiving 4.2% a year return by selling the call options against your position, which retain about 2% of upside potential per month.
With the LEAPs portfolio, you have approximately $78,036 in cash, plus an allocation to $100,000 of the S&P 500 index. The S&P 500 index allocation will be similar to the returns as experienced above, because the deep in-the-money call option will move point for point with the underlying stock. Now the difference comes with the extra $78,036 in cash, to make the example easier we will invest it all into 3-month T-Bills currently yielding 5.16% a year. This will add an additional $4,026 in cash per year. Taking the $4,026 gained from the T-Bill investment and the $4,200 in cash received from selling the covered calls, you are receiving about $8,226 or 8.23% a year on the $100,000 LEAPs portfolio. This is double the amount you would be receiving from just the $100,000 portfolio invested fully in the S&P 500 index fund.
I didn’t forget about the premium to the current stock price that you had to pay for the LEAP call option, but one year of premiums or one year of T-Bill payments will pay for the additional premium you owed.
This strategy puts less money at risk than a traditional investment portfolio, and if you put that extra ~$75,000 of cash into bonds, you can potentially increase your returns and hedge against a market downturn, since bonds tend to move opposite of stocks. This strategy can give a $75,000 allocation to bonds and a $100,000 allocation to stocks, which is deemed to be very conservative, all of this on a total investment of $100,000 using the LEAP option strategy. This strategy also can handle a 50% decline in stocks, such that was experience after 1999, if the S&P 500 were to experience this sort of decline in the next two years, the all index portfolio would now be worth approximately $50,000 plus any premiums, while the LEAP option strategy would be worth approximately $75,000 plus any interest and premiums received.
This strategy can also be applied to the index if you expect it to go down, all you would do is use Put options instead of the call options.
