"Covered calls on Apple (NASDAQ :)" was the theme we discussed at length last week. In the previous post, we noted that buying 100 shares of Apple would cost about $ 13,500, a significant investment for many people.
Some investors prefer to put together a "covered call for poor people" on the stock instead. That's why today we're introducing a diagonal debit spread on Apple, which is sometimes used to replicate a covered call position at a significantly lower cost.
Investors new to options may want to review last week's article (link above) before reading this article. For many readers, today's piece should help broaden their understanding of options. For more experienced investors, it likely offers ideas for future trades.
LEAPS Options
Let's take a look at the LEAPS options first.
LEAPS stands for "Long-Term Equity Anticipation Securities." Readers can also see websites that refer to them as LEAP options or LEAPs.
Investors who believe in the long-term growth potential of underlying assets, such as stocks or exchange-traded funds (ETFs), should consider using LEAPS options, which are long-term, usually one to two years until the expiration date.
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Investors like LEAPS because they "cost less" than stocks, that is, they are offered at option contract prices.
However, there are no free lunches on Wall Street. Being "cheaper" comes at a price. As with all options, LEAPS have expiration dates when the "predicted" move should end.
As these are long-term investments, the participants have a relatively long time (i.e. about two years, depending on the option chosen) to follow the price movements of the underlying asset. Nonetheless, they still expire and the trader could lose all invested capital if the expected move does not go ahead.
Therefore, before jumping into LEAPS, an investor should be clear about his hedging requirements or speculative objectives. Within their risk / return parameters, they need to understand how these long-term options can help.
Investors interested in learning more about LEAPs trading strategies can consult the educational websites of the Options Industry Council (OIC), Cboe Global Markets or the Nasdaq Exchange.
A Diagonal Debit Spread On Apple Shares
Current Price: $ 136.91
52 Week Range: $ 53. 15 – $ 145.09
One year price change: Up 71.12%
Dividend Yield: 0.60%
A trader first buys a "longer term" call with a lower strike price. At the same time, the trader sells a “shorter term” call with a higher strike price, creating a long diagonal spread.
In other words, the call options for the underlying stock (i.e. Apple in this case) have different strikes and different expiration dates. The trader goes long one option and short the other to create a diagonal spread.
In this LEAPS backed call strategy, both profit potential and risk are limited. The trader establishes the position for a net debit (or expense). The net depreciation represents the maximum loss.
Most traders adopting such a strategy would be slightly optimistic about the underlying asset – here, Apple.
Rather than buying 100 shares of Apple, the trader would buy a deep-seated LEAPS call option with that LEAPS call acting as a "surrogate" to holdings of the AAPL stock.
As we write this, Apple is priced at $ 136.91.
For the first leg of this strategy, the trader can purchase a deep in-the-money (ITM) LEAPS call, such as the AAPL January 20, 2023, 100-strike call option. This option is currently on offer at $ 47.58 (mid-current bid and offer spread). In other words, it would cost the trader $ 4,758 instead of $ 13,691 to own this call option, which expires in a little less than two years.
The delta of this option is 0.80. Delta shows the amount that an option's price is expected to move based on a $ 1 change in the underlying asset.
In this example, if the AAPL stock were to rise $ 1 to $ 137.91, the current option price of $ 47.58 is expected to increase by 80 cents based on a delta of 0.80. However, the actual change may be slightly more or less based on various other factors that are beyond the scope of this article.
So the delta of an option increases as one goes deeper into the money. Traders would use deep ITM LEAPS attacks because as delta 1 approaches, the price movements of a LEAPS option begin to mirror those of the underlying stock. In simple terms, a delta of 0.80 in this example would be the same as owning 80 Apple shares (as opposed to 100 in a regular covered call).
For the second part of this strategy, the trader sells an out-of-the-money (OTM) short term call, such as the AAPL March 19, 2021, 140 strike call option. The current premium of this option is $ 4.30. In other words, the option seller would receive $ 430, not including trading commissions.
There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a breakeven point in this transaction.
Various brokers or online websites may provide "profit and loss calculators" for such a strategy. Calculating the value of the last month (ie LEAPS call) when the first month (ie shorter date) call option expires requires a pricing model to get an "estimate" for a breakeven point.
Maximum Earnings Potential
The maximum potential is realized when the share price equals the strike price of the short call at the expiration date of the short call.
In other words, the trader wants the Apple stock price to stay as close as possible to the strike price of the short option (ie $ 140 here) at maturity (on March 19, 2021), without going above it.
In our example, the maximum return would theoretically be about $ 677 at a price of $ 140.00 at maturity, excluding trading commissions and fees.
How did we arrive at this value? The option seller (i.e. the trader) received $ 430 for the option sold.
Meanwhile, the underlying Apple stock rose from $ 136.91 to $ 140, a difference of $ 3.09 for 1 share of Apple or $ 309 for 100 shares.
Because the delta of the long LEAPS option is 0.8, the value of the long option will theoretically increase by $ 309 X 0.80 = $ 247.2 (in practice, however, it can be more or less are then this value).
The total of $ 430 and $ 247.2 comes to $ 677.2
By not initially investing $ 13,691 in 100 shares of Apple, the potential returns of the trader are thus exploited.
Put another way, the premium the trader initially receives for the sale of the shorter call option (i.e. $ 430) represents a higher percentage of the initial investment of $ 4,758 than if the trader purchased 100 shares of Apple for $ 13,691.
Ideally, the trader hopes that the short call will be out-of-the-money. Then, the trader can sell one call after another, until the long LEAPS call expires in about two years. novice traders.
If Apple moves above $ 140 on March 16, the position will yield less than its potential maximum return as the short-term option begins to lose money.
Then the merchant might feel the need to close the trade early as the Apple price skyrockets and the short conversation goes deep into ITM. In that case, the trader may have to close the whole trade and start over, or put together alternative options strategies.
In a normal covered call, the trader does not necessarily mind being assigned the short option as he / she also owns 100 Apple shares. However, on a covered call from a poor person, the trader would not necessarily want to get the short call as he / she does not own those AAPL shares yet.
On March 16, this LEAPS-backed call trade would start to lose money if Apple's stock price falls to about $ 132 or below. In theory, the price of a stock could fall to $ 0, decreasing the value of the long call.
Finally, we should also remind readers that deep ITM LEAPS options typically have high bid / offer spreads. Thus, any time the trader buys or sells such a LEAPS option, there can be significant transaction costs.
