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This is a level 2 question.
What happens if you buy a deep-in-the-money LEAPS call, and you sell a short-term out-of-the money call against it? For example, stock XYZ is trading at 55, and I buy a January 2002 30 call for $22, and I sell an October 60 call for 5.50. What happens if on October expiration the stock is above 60 or below 30?
The example you give is a quasi-covered call strategy. Remember that a covered call involves selling a call on a stock that is already owned or is simultaneously purchased. You can substitute a LEAPS call purchase for the purchase of the actual shares of the underlying stock; however, it does carry more risk if you happen to be assigned the shares. Covered calls are appropriate for investors who are neutral to mildly bullish on the underlying equity.
Before we go any further, we need to revise some of your price assumptions. The January 2002 30 call on XYZ will unquestionably cost more than 22. Remember that an in-the-money option will have both intrinsic and time values. The intrinsic value is the amount that the option is in the money, and the time value is derived by subtracting the intrinsic value from the current premium. In your example, the January 2002 30 call would have an intrinsic value of 25 (XYZ stock price of 55 minus the strike price of the call). Because it's a LEAPS, it will also have substantial time value. So, let's adjust the purchase price of the LEAPS call in your example to 35, which gives the option a time value of 10 (price of option minus intrinsic value). By the same token, out-of-the-money options have only time value. Since the October 60 has only one month left until expiration, a premium of 5.50 is on the high side. To make it more realistic let's assume that you receive a premium of 1.
The revised example now involves stock XYZ, which is still trading at 55. The January 2002 30 call is purchased for 35, and the October 60 call is sold for 1, which results in a net cost of $3,400 ($3,500 purchase cost of LEAPS less $100 received for the sale of the call).
If XYZ rallies and closes above 60 at expiration, in all likelihood you will be assigned the shares. This is where the quasi-covered call differs significantly from the covered call. In a covered call strategy, you would simply hand over the shares that you already own. With your strategy, you have two choices; you can exercise the LEAPS and acquire the shares at less than half of the current market price, or you can sell the LEAPS, which will have appreciated nicely, and use the proceeds for the purchase of the stock in the open market.
Typically, you'll be better off selling the LEAPS because you will capture both the intrinsic and time values of the option. For example, let's assume XYZ rallied and closed at 64 at October expiration. You could exercise the LEAPS call, which will result in a $3,400 discount on the current market price of XYZ. However, the January 2002 30 call could be worth around 43.50 at October expiration. You could sell the call and use the $4,350 to offset the cost of acquiring XYZ.
If XYZ falls and closes below 30 at October expiration (an extremely unlikely event), your action will depend on your outlook for the stock. If you think XYZ still has some downside, you may decide to sell back the LEAPS and close the position entirely. The loss you take on the LEAPS position will be slightly offset by the $100 premium you received for the sale of the October 60 call. However, if you think XYZ will rally substantially over the next year or so, you may want to hold on to the LEAPS in order to have exposure to that potential upside. You can even choose to write another call against the January 2002 30 call in order to collect additional premium to further offset your losses on the LEAPS position. In fact, if you wrote a covered call at 1 every month until January 2002, you could conceivably collect a total of $1,600 if all the options expired worthless. This would defray about 45 percent of the original cost of the LEAPS.
Again, it all depends on your outlook for XYZ, your risk tolerance, and your investment objectives. Thanks for your question and good luck with this strategy.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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