News Snapshot

• Stocks Surge to Record Close Despite Inflation and Interest Rate Worries

• January Options Trading Activity Could Set the Stage for the 6th Straight Record-Setting Year

• Bank Fights Fraud Claims Over Frank’s “Creative” User Numbers

• Trump Lawyers Downplay Musk’s DOGE “Mastermind” Status

TL;DR

“Good-To-Know’s”

Why Use a LEAP?

Theta decay accelerates as the option nears expiration, so options with longer timeframes retain their value longer, allowing more time for the underlying to move. When buying options closer to expiration, they lose extrinsic value more quickly, as theta is not linear (illustrated below):

Thought Throttle

Has there been a stock in which you wish you could own 100 shares and utilize the covered call strategy, but the cost of 100 shares was too substantial for your portfolio? Missing out on opportunities due to capital restraints can be frustrating, but there are alternative paths to replicate these trades. To set up a covered call, but with less capital, we can look at a Poor Man’s Covered Call (aka PMCC; Diagonal Spread).

A PMCC occurs when, instead of owning the underlying (like in a CC), you buy a call option (usually a LEAP) on the underlying, and then sell a call option at a closer expiration date and a higher strike price. The purchased call option is what covers you from the unlimited potential loss associated with selling ‘would-be’ naked calls.

If you were bullish on a stock in the long term and just slightly bullish in the short term, you could utilize the PMCC. You would choose the strike price and delta based on your level of bullishness and how much assignment risk you're willing to take on. It is best to be shown in an example using AMZN:

On January 2nd, 2024, Guy decides he is bullish on Amazon over the next year. AMZN opens at $151.54 that day. Instead of purchasing 100 shares of AMZN, which would cost $15,154, he purchases a LEAP. He selects the 17 Jan 2025 expiration call with ~70 delta, which is the $135 strike call. The purchase of this call option costs $3,215.

To offset some of this cost, Guy decides to sell a shorter-term call option against the contract he just purchased. He wants a lower assignment risk and would accept the corresponding lower premium, so he decides to sell a call option with a delta of ~15. Right after purchasing the call on Jan 2nd, he sells the 15 Mar 2024 call option with a strike of $175 (~15 delta), and he receives the premium of $141.

On March 11th, the Monday before the option expires, he decides to close the sold call, as he does not want to hold until expiration. The cost to ‘Buy-To-Close’ this contract is $105.

Guy continues rolling the sold call on the Monday before expiration for the ~15 delta call option with ~60 DTE. Summarized below is the list of ‘short-call’ trades:

On November 11th, after Guy closes his sold November 15th, $215 Call, he also decides that he will exit his $135 Long Call, as it now has 67 DTE. He sells this option for $7330.

When we calculate all the net premium he received, along with the gain from his LEAP option, we see that he received a return of 149.83% over the course of the trade, from the initial purchase on 01/2/2024 to the sale on 11/11/2024, which is a total of 314 days. This gives us an annualized return of 189.89%. We can compare this to the outcome if he had been using a traditional covered call. Guy would have purchased 100 shares on 1/2/2024 at $151.54/share, and then sold all shares on 11/11/2024 at $206.84/share. With all else remaining equal, he would have received a 41.12% return, which is an annualized return of 49.25%. Still, a very good return.

In November, Guy sold the LEAP as its expiration was approaching, though this may not have been when the stock position would have been exited in a traditional CC. This was done for comparison purposes, but one key advantage of owning shares outright is that there’s no expiration to manage. Additionally, returns can vary depending on the specific delta of the LEAP selected, adding another layer of nuance to the overall strategy.

This comparison highlights the power of leverage and the strategic flexibility offered by LEAP-based covered call strategies. While the traditional covered call provided solid, consistent returns, the poor man’s covered call significantly outperformed due to the lower capital requirement and amplified gains from the LEAP’s price movement.

However, it is important to note the additional complexities involved with PMCC’s, such as managing expiration risk, rolling short calls, and selecting the right delta for optimal performance. Investors considering this strategy should weigh the benefits of higher returns against the nuances and risks involved, ensuring it aligns with their risk tolerance and investment objectives.

Relevant Quote I Like

Throttle Q&A

What does "delta" mean in options trading?

Delta measures how much an option’s price changes for every $1 move in the underlying stock. For call options, delta ranges from 0 to 1, meaning a delta of 0.70 would cause the option price to move $0.70 for every $1 change in the stock. For put options, delta ranges from -1 to 0, so a delta of -0.40 means the option price moves $0.40 opposite to the stock’s movement.

Delta also gives an estimate of the probability that the option will finish in the money by expiration, and is utilized in position sizing, helping traders manage exposure to the underlying asset by adjusting the number of contracts they hold based on their desired risk/reward.

How are the premiums received and the gain from the LEAP in a PMCC taxed?

The way income is taxed is based on the holding period of the instrument and is usually as follows:

1. Premiums from Selling Short-Term Options are generally taxed at short-term capital gains rates. This is because they are held for less than a year, and would be subject to ordinary income tax rates (usually higher; not ideal).

2. Gains from the LEAP are generally taxed at long-term capital gains rates since LEAPS are often held for greater than a year (if you are rolling your LEAPs, this may not be the case). Long-term Capital Gains Rates are generally more desirable than short-term (ordinary) rates.

If the LEAP is exercised, gains from selling the underlying stock are taxed based on the holding period of the stock. Always consult a tax professional for specific guidance.

How do options work in a retirement account (e.g., IRA)?

Options can be traded in a retirement account like an IRA, but with some restrictions depending on the broker and account type. Typically, IRAs allow covered calls, cash-secured puts, and buying calls or puts, but they prohibit strategies involving margin, naked options, or uncovered selling. Since IRAs don’t allow borrowing, trades must be fully collateralized with cash or securities. Approval for options trading in an IRA is based on the account holder’s experience and risk tolerance, often categorized into different trading levels.

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