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Strategies & Market Trends : The Covered Calls for Dummies Thread -- Ignore unavailable to you. Want to Upgrade?

To: RP Svoboda who wrote (1661)	7/29/2001 4:43:57 PM
From: alanrs	Respond to of 5205

My options experience is limited to covered calls, naked puts, buying calls outright, and buying bull spreads. I have never taken a diagonal (both different strike prices and different expiration dates) position before. That's more experience than I've got with options. I'm hoping Dan or Mathemagician or William will give the questions that followed that a try. Do you have access to an option position analyzer program? ARS

To: RP Svoboda who wrote (1661)	7/29/2001 4:59:36 PM
From: BDR	Read Replies (1) \| Respond to of 5205

With the diagonal spread you describe (Long ITM LEAPS Calls and short near term OTM Calls) I would think you would want in most cases to continue to hold the LEAPS, letting the calls expire or rolling them up and/or out if they end up ITM at expiration rather than liquidating the entire position. In the example you gave you could by back the calls for a profit of 2. You would still have the, as yet, unrealized profit of 6 in the LEAPS position. You could then sell another call against that position at the same or higher strike price. By buying deep ITM LEAPS you should be protected, in the event the stock runs away from you, by a higher delta for the LEAPS than the call. You will have a loss on the call but the gain on the LEAPS should be equal or higher than that loss. You could buy back the call, record the loss and sell another call (psychologically not as satisfying but realistically it shouldn't matter) or you could close out the entire position for, one hopes, a net gain. If the call is ITM at expiration I don't think your broker will liquidate both the LEAPS and the call without express instructions from you. I think the call will be exercised, leaving you short the stock and long the LEAPS. dDR, who thought he would do diagonal spreads with ITM RMBS LEAPS and now finds himself long OTM LEAPS :(

To: RP Svoboda who wrote (1661)	7/29/2001 5:50:27 PM
From: Dan Duchardt	Read Replies (2) \| Respond to of 5205

Boda, While legging into a diagonal position, at first I thought that I needed to write a covered call for at least the strike plus the amount paid to purchase the long call. For example if I paid 25 to buy the 04 Jan 50s then I needed to write at least 75 to break even. However this cannot be the case because of the intrinsic value in the 04 Jan 50s. A rule of thumb for the diagonal spread is that the net return from being called out on the near term short call should be no less than the cost of purchasing the stock by exercising the long call. In your case it would cost you $75 if you bought via exercise, and since the premium on the near term OTMs is so small, the 75 is the lowest strike that satisfies the rule. But as you have suggested, the rule does not well fit the situation where the exercise dates are so far apart, not just because of the intrinsic value of the long LEAPS, but because of the remaining time value they will retain at the expiration of the near term calls. The time erosion of the long LEAPS premium over the life of the ear term short call is negligible. You can in fact be more aggressive than writing the 75 calls without putting yourself at risk of a net loss. An option position analyzer like the one from CBOE, or an Excel based one I found recently that I like better (free from hoadley.net can be very helpful in projecting the best balance between risk and reward for the different near term strikes. Right now, the analyzer is showing that with your cost basis of $25 on the 2004JAN50, you could sell the AUG55 and not go negative unless QCOM hits 120. But that is not your objective at this point. What you really want to do is improve your situation every month, so the real comparison should be based on where you are now, holding a 2004JAN50 call that is worth $30.80 (I see one bid at the moment for 30.90) If we use that as the basis for looking forward, with the idea of always improving, selling an AUG55 would create a loss of QCOM goes above about $68. Not that you would want to sell a 55, but it illustrates that using "now" as the basis for valuing the long LEAP changes the picture considerably. The best you can hope for in selling the near term call is to capture a decent time premium, and have the option expire worthless. Right now the best time premium would come from selling the AUG65 for $2.50, (the model says the fair price is higher than that) If QCOM goes up a bit more you might get $3.50 of time value. Even at $2.50, the model predicts breakeven at about $90 for QCOM. In other words, if you had to sell your LEAP and buy stock to meet assignment you should come out ahead for any price between about $65 and about $90. If you got $3.50, the breakeven point would move up to $100. For near term strikes above $65, the upside potential improves, but at the expense of premium. If you sold he 70s for the current best bid of $0.90, and if the stock made it to $70, you would do better than selling the 65 and having it close there, but if you sold the 70, and it closed at 65 you would do less well than having sold the 65. So what do you do with all this? I think the best you can do is to sell the strike that is most likely to be ATM at expiration time, as long as it is high enough so you are confident the stock is not going to run higher than the point where you would break even. That strike might very well be ATM or even somewhat ITM if you think the stock is due for a pull back. I've tried to think of a rule of thumb that would help identify a relatively safe strike to shoot for without resorting to detailed modeling. I think you can get a good idea from comparing the "delta" of the near term calls to that of the long LEAPS. In this case, the 2004AUG50 has delta = .79. It will not change much with the underlying, but will creep slightly higher if it goes up. A near term ATM call has a delta near .50, and will go up rapidly if the underlying rises. The point at which the near term delta equals the long LEAPS delta is when things start going the wrong way. I'm thinking that the selected near term delta should be at least twice as far from 1.00 as the LEAPS delta. In this case that point is 1.00-(2x(1.00-0.79))=0.56. The AUG60 delta is a bit too high at .67. The AUG65 is a bit low at .45, but as we saw from the detailed model, it's a pretty safe choice. Maybe someone has a better rule or can cite one from one of the reference works. When you are using a different option to cover a call, how does the execution on the expiration date occur? You need to check with your broker to be sure, or maybe to arrange specific instructions. Sinde the LEAPS is not expiring, there is no reason to expect it will be exercised, and you certainly don't want it to be. The most likely thing is what happens if you have a naked ITM call. You are assigned, and you wind up short the stock at the strike price. Then you have to carry the short, or buy the stock to close it. Dan PS. I see that my slow thinking and typing has been overtaken by other replies. <ggg> Dale has given good advice I think about what to do if the near term call expires ITM. Hopefully this adds something useful about the selection of which strike to write.