Writing calls that are secured with a leap what is the risk?

Question

If I buy the qqqq 45 leap out to jan 10 today it would cost 6.50 then can I sell the August 45 call for .85 and do this month after month. what is the risk and what do i stand to loses and gain fromthis type of trade.

Answer 1

First of all, forget about the idea that you can "sell the August 45 call for .85 and do this month after month."  In theory it is possible, in practice it will not happen. The underlying will either go up or down long before 2010.

While planning to sell monthly near-term calls at $45 is fine if the stock stays where it is, you also need a plan that tells you what to do if the stock goes up or if it goes down.

If the stock goes down any significant amount, you will no longer get $0.85 for the short term $45 call. You may only get $0.10 or $0.15, not enough to cover your losses on the LEAPS. You could sell a call with a lower strike price instead, but then you risk getting whipsawed if the stock goes up. You could sell a call more than a month or two out to get a higher premium, but then you would not get as much from the time decay (theta) of the option you wrote.

If the stock goes up any significant amount, your short call will be in the money. You will have choose between buying back the option (likely for a loss) or doing nothing, thereby selling the stock when assigned. Your plan needs to include when to roll the option and when to simply accept a loss and close the position.

The gamma risk of near-term at-the-money options is as high as it gets. If you do not know what gamma risk is, or have some idea how to control it, you probably should learn more about options before trying such spreads.

A calendar spread (also known as a time spread) usually works best when there is an increase in the implied volatility (IV) of the options. Because the vega of the LEAPS will be higher than the vega of the near-term option an increase in IV will increase the value of the LEAPS more than it increases the value of the near-term options.

Another part of your plan should include how you will handle expiration weekend when you short calls are out of the money. If you simply let them expire your long calls are unhedged all weekend long. If you do not want to be unhedged, you need to roll the short calls before expiraiton.

One good thing about the spread is that the risk is limited to ($650 - $85) = $565 per contract if, and only if, you do not put more money at risk trying to adjust the position.

If you are good at adjusting spreads as the price of the underlying mores, or if you are just plain lucky, you can make a good profit form this spread. In my opinion, however, it would be easier to lose money than make it.

Answer 2

If the stock goes up pass $45 you will have to sell it for $45 or buy the option back either way it would result in a loss for that month.  Also if the stock crashes to say $35 your leap would be worth a lot less which can also result in a loss.

Answer 3

It can be done, but your risk is the original capital and not participating an any upside above 45.  Plus you have transaction fees as well as possible taxes.  You should build a spreadsheet to determine what the payoffs are under various strike prices to see what your gain is.  If this is not on margin and you are only writing covered calls against the position, it would seem that the loss would be the original call cost and fees.  It seems you may need to do more research into options before you try this though.  It may not be worth it after you model the trades.

Answer 4

Leaps reach out further than options and consequently have a potential for wider swings due to the longer term to appreciation.  

Answer 5

It'll work in a stable market.  A sharp drop in the NASDAQ would still give you a loss, although hedged a bit by the calls you sold.  A sharp rise in the NASDAQ could also give you a loss - delta will be higher with the shorter-term option so you'd lose more than you'd gain on the LEAP.

LEAPs generally are illiquid so you get a lot of slippage on them too.

It might be a good strategy long-term.  You'd be selling time at a premium with the short-term options.  You'd be buying it at a discount with the LEAPs.  That should on average give you an edge, but I'd pilot it a year or two with risk capital before investing a lot in it.

Answer 6

If you are asking this over the internet you need to do some more hard research. Options are fascinating but without a firm background you can lose your shirt. Are these calls covered or naked? If you can't answer immediately, do more reading. I mostly do covered calls and earn between 15 to 20 percent. Another thing you did not mention was fees. These can eat out any potential for profit.