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

To: William who wrote (2002)	8/14/2001 11:54:20 PM
From: Dan Duchardt	Read Replies (2) \| Respond to of 5205

William, Help me out on this one. Say you do exactly what you said, buy a GE 2004 Jan 20 and sell Sep 42.5. OK. Now, on Sept 21, GE closes at 51. What do you do. You have to deliver 100 Shares of GE and you are going to be paid $4250 for them. You don't have them. What action do you take? That certainly cuts to the heart fo the matter. First I'll give an oversimplified answer, and then a better one that is a bit more involved. When you bought the 2004JAN20 calls for $23.30, you purchased the right to buy GE at $20 anytime before that far away expiration. You also collected $1.50 for the sale of the SEP42.5. The absolute worst thing that could happen is that you could acquire the stock by exercising your option. Your net cost would be $4180. So the net result is you make $70 on a net investment of $2180 or 3.2% (neglecting commissions). The simple rule of thumb is that you write the LEAPS far enough in the money, and the near term calls far enough out of the money so that if called out and you have to obtain stock through LEAPS exercise you at least break even. Because the LEAPS track the underlying so well to retain value, you could actually buy LEAPS at a higher strike, violating the simple rule of thumb, and still come out ahead if called. In fact, you can often improve the percentage gain on the money put at risk by doing so because you risk less to begin with. Now looking a bit deeper, if as you say the stock goes to 51, how much is that long LEAPS going to be worth? The projected value at September expiration if the stock is at 51 is that the LEAPS will be worth 33.30. There will be very little erosion of time value, only about $10. Say you lose $30 to the spread, and manage to sell the LEAPS for only 33.00. You buy the stock for $5100, and you sell it for $4250, but you made $3330 - $2180 on the LEAPS. Your net profit is $300 on $2180, or 13.75% on the money you put at risk, or 7% on the full value of the underlying stock ($4185). And of course you get that same return even if the stock only goes to $42.50. The goal of this strategy is not to get called out, so it is very much like being attached to your underlying shares. But if the price gets too high you can always unwind as described above and wait for the stock to come back to you or find another one. All the usual repair techniques that apply to CCs apply here as well. You could roll out from the September to October, and with the stock at 51 maybe roll up to 45 in the process. You don't have to write near month, but can instead write a few months out as some prefer. And you can do all the usual trading in and out of near term calls you do when you own the stock. Herm Matos, who started the other Covered Calls thread, has shifted his CC writing to this strategy and he has started a pay service now for those who are interested. He still has some freebies at his site. I don't especially like the way he calculates things, but it's just another way of presenting the same thing Subject 12574 Dan