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Posts Tagged ‘selling OTM calls’

Trading Covered Calls by Legging In

This strategy is a variation of the out-of-the-money (OTM) covered call strategy.  When you are anticipation a market upturn such as a bounce up or your stock is in a prolonged uptrend, this strategy may work for this type of situation.  The legging in strategy is to buy the stock and then wait for the price to increase before selling OTM calls.  The legging in is related to the buy the stock (one leg) before you sell the calls (second leg) at a later date to complete the covered call trade.

This strategy can significantly increase your returns when the stock price moves up rapidly.  Then, you have a decision to make about when to sell the call.  Some traders decide that the stock will continue to rise so they do not sell the call.  Others may decide the stock is out of gas to move higher so they will
sell an OTM call for additional income.

As an example, you may purchase a stock at $52.40.  The current month 52.50 call strike is selling for $1.00.  You can buy the stock at $52.40 and sell the 52.50 call for $1.00 and get an unassigned return of 2.14%.  You don’t want to lock in your covered call trade for a low return so you wait on the stock.  To leg in to this trade, you would buy the stock and wait until its price increases to around $54.00.  At this time, the 52.50 call strike price is $2.50.  The leg in trader
would sell the 52.50 call strike if the stock was out of momentum and poised for a pullback.  This would create an assigned return of 5.01%.  This return is more than double the initial trade with a downside protection to $52.50.

The leg in trade more than doubles the unassigned return because the option premium more than doubled (from $1.00 to $2.50) as the stock price increased.  The return percentage doubled while both trades were at the same strike price (52.50).  This could be even better if the trader moves their call strike price
to 55 to let a stock continue to run up to a higher price.

So what is the trade off for the additional return?  Legging-in is a little speculative because it leaves the investor without a premium for a short time
while waiting for the stock price to increase.  Additionally, the trader does not have the downside protection while owning only the stock without selling the
call.  Lastly, the investor could be wrong and the stock never increases in price.

The bottomline is that the trader must have a solid reason for why the stock will increase in price in the short-term.  the moment this rationale is proven wrong, the trader must make a decision on how to proceed with the stock they own.

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