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How to Manage Risk with a Covered Call & Leap Strategy

When entering a covered write with a LEAP, the investor hopes that the short-term call written against the LEAPS will expire worthless.  The investor can then “roll” the short-term call to further-out months with the goal of collecting additional premium month after month.

There are three risks with covered call – LEAP strategy:

  • Stock price decline
  • Assignment (creates a short stock position)
  • Stock price rise can reduce profit

Managing actions should be planned in advance.

If the price falls too fast you have these options:

  1. Close position and realize the loss.
  2. Roll Down and Out by covering (buying back) short call and then selling lower strike call with later expiration date.
  3. Maintain position – hope for price rise.  Let short Call expire and keep LEAPS Call.

 

What if the short call is assigned when stock price rises above call strike price?  Here are some options:

  1. Close the whole position
  2. Buy stock (to cover): stay long LEAPS Call
  3. Buy stock (to cover) & sell another Short-term Call (now have a new LEAPS covered call).

If the stock price rises too much, your profits will be reduced.  Why are profits reduced if the stock price rises too much?

It’s called the “effective price” concept.  If a call is exercised, then stock is purchased.  The effective purchase price of the stock is the strike price plus the call premium.  For example:

Buy a 50 Call @ $3.00

If the call is exercised:

The total cost of the stock is $50 + $3 = $53

$53 is the effective price.

The following example shows how to calculate effective price:

Stock XYZ @ $53.80

Long 1 XYZ 18-month 45 Call @ $10.60

Short 1 XYZ 60-day 55 Call @ $1.25

Strike  +   Call Px  =   Eff Px

55 Call           55      +     1.25     =  56.25 Sell

LEAPS Call   45      +     10.60 = 55.60 Buy

Maximum Profit = +0.65

 Profit at expiration of short call can be higher if there is time premium in the LEAPS call.

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