Last update: August 2021
David posed an insightful question in the clubhouse that I wanted to highlight in today’s blog post. The gist of it had to do with better leveraging an IRA by selling covered calls on long-term call options (aka LEAPS) instead of stock. Since this is a very common question let’s break it down.
First, we all love the idea of cash flowing a stock. The principal drawback is the excessive capital cost of purchasing 100 shares. Of course, you can lessen the sting by having a margin account. In that scenario, you only have to put up 50% of the stock cost. For example, instead of having to tie up $10,000 for a $100 stock you only have to commit $5,000.
Unfortunately, in an IRA account, you don’t get the favorable capital requirements. That means you always have to put up the full purchase price of the stock. And that’s a bummer if you don’t have a large account. This, I suspect, is the motivation behind David’s question.
The short answer is, yes, you could substitute the long stock with a LEAPS call option. Remember, 100 shares of stock boasts 100 deltas. So if you’re going to buy a call that mimics the behavior of a long stock position it needs to sit deep in-the-money and have a high delta. Say, 80 or higher.
Once you’ve purchased the long call, you can proceed to sell short-term out-of-the-money call options (a covered call, in essence) against it.
The main risk I see with this approach is if the stock drops considerably. The long-term in-the-money call option will move closer to the current stock price, and its delta will drop towards 50. At that point, it’s not an effective proxy for long stock, so your trade won’t behave like a covered call anymore. To fix the trade, you’d have to sell the LEAPS call and replace it with a deeper ITM one possessing a higher delta.
Here’s a basic example of the trade setup using XOP.
Covered Call: Buy 100 shares at $41.80 ($4,180 cost), sell the Mar 43 call for $1.03
LEAPS Covered Call: Buy one Jan 2018 32 strike call for $10.85 ($1,085 cost), sell the Mar 43 call for $1.03.
The risk graphs of both look similar. But with the LEAPS Covered Call you’ve cut the cost from $4,180 to $1,085.
Another idea worth trying is selling bull put spreads instead of covered calls in an IRA. If you’ve taken Legacy’s Options I class, then you should know that naked puts and covered calls are equivalent positions. Since you have to put up 100% of the max loss in an IRA, the naked put trade costs the same as a covered call, so there isn’t much difference between the two.
What you might consider is selling a naked put and then buying a far out-of-the-money put simultaneously to cut the risk (and therefore cost) of the position. This creates a wide bull put spread.
Continuing with the XOP example, I could sell a March 40 put (it’s slightly OTM and has a -0.31 delta) for 88 cents and buy a Mar 33 put for 5 cents. This creates a $7-wide bull put spread for a net credit of 83 cents. The potential risk (and therefore cost) is only $617. That’s a far cry from the $4,180 or so we had to put up for the covered call.
To keep the sizing consistent, I would sell one bull put for every 100 shares of stock I was planning on selling covered calls with. Personally, I find the idea of selling these wide bull puts month-to-month instead of LEAPS covered calls more attractive.
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