Selling calls against Leaps

There are guru's out there advocating this approach as a way to generate on-going cash flow. The claims are that it is a better way to go than covered calls. I'd appreciate any comments from the wise heads of this forum

 

Upside is the weakness -- not enough long gamma on the long LEAPS to compensate for the short gamma in the front month write.

P&L favors a flat/mildly-declining market.

 

Like anything else, when it works, it's great. When it doesn't, you better not have all of your account in it.

If you use a deep ITM Leap call as the long and sell the near-money next month call, it can be thought of as (somewhat) similar to a leveraged covered call, at least for smaller underlying moves. And as such, could be done just with short puts. But there are many many variations, strikes, and trading around the position that can be done.

To show you how bad it can be, go to Terry's Tips and ask how he did this year. Terry's accounts that used this strategy lost better than 80% this year. And Terry has been trading options for 20 years. He should have known better IMO.

Hopefully the options gurus here will stop by and offer deeper insight and better advice. Good trading to you.

 

Received 2 e-mail solicitations from him just recently.

First on 9/9 with the Subject "How I Plan to Make 49% in 3 1/2 Weeks" and a careful reading of it reveals that it is selling strangles on MSH.

Second on 9/15 with the subject "49% in 22 Days Not Looking Good", as his b/e on the upside is 446 on MSH.

Not saying any strategy itself is wrong or right--just wondering what his exit plan is, because I heard that with the one of the time spread strategies on QQQ he advised, he violated his own "rules" and doubled down, leaving his advisees on autotrade bleeding.

 

Can't you avoid that by rolling over the short contract to a higher strike in the next month, if the underlying rises?

Theta is more important here, namely the fact of exponential decay in the last 30 days, the very month you are selling short. Theta is your friend in a calendar spread.


A platform like Cybertrader lets you rollout like this for 1 base commission only. I may try this strategy with ITM calls on a mildly medium term bullish stock - QCOM maybe

 

Yes, this strategy can work and work well. Turning an 80-100% annual profit is not too hard...BUT you need to have that stock move like you predict (hope?) most of the time.

This is what can and will happen: You do the spread. The stock doesn't move much and you bag a sweet gain. You roll the short to the next month ATM. The stock zooms. The gamma on the long doesn't quite keep up with the negative gamma on the short. You lose a bucket of money until you buy back the short at a bitch loss. You write next month and the f*cker DROPS like a brick. Those couple points from the write stop covering the huge loss on the long leg after a little while, so you buy back the worthless short and roll the short back out and maybe the long if it got too near the money. And so on, etc...

That's the kind of thing that happened to Terry this year and to me when I did them 1999 - 2001. I propose that if you can predict the stock move well enough, just trade it. Or perhaps just crank out a regular short put strategy (probably on an index, with low leverage) and you can make 10 - 20% year. Not too bad for almost zero stress...

 

Riskarb is right -

The gamma (i.e. the rate of change of delta, and the relative lack of it, at least early on, in the leaps calls) can really hurt you if the underlying price goes up (unlike in a standard covered call), and you can also get hurt if the underlying price goes down too much, (like in a standard covered call). As the price goes up, the short will lose more and faster, than the long can cover, until the price gets much higher. To help off set this, in putting this kind of combo trade on, if you do, try and match the options so that, relatively speaking, the volatility 'skew' is high (i.e. the implied volatility of the long option is lower than that of the short option). And, correct that, like a standard covered write (buy stock - sell call), it has a risk profile like that of just selling a naked put, especially the more in the money the long call is (the less so then the risk profile gets to look more like a curved bull call spread, or a tilted calendar spread.

With a standard covered call, the downside risk is the entire value of the underlying, less the premium of the call sold, and the there is no upside risk, except opportunity cost because you have capped your upside potential in having sold a call against your long. On the leaps covered call, there is also the risk of entire loss of the long option (the leap) if the underlying plummets, but there is also, unlike the standard covered call, theoretically unlimited risk if the underlying price rockets skyward (the upside loss rate does diminish as the price goes higher though, since the gamma of long will eventually catch up with the gamma of the short as the underlying price gets farther away from the two strike prices).

Some Alternatives (all of which have different risk profiles) to consider :

1. If there is more bullish risk in the position then buy in the money leap (not at or out of money), sell out of the money nearer term call (not at the money). This is analogous to standard bull call spread (buy lower strike call sell higher strike call) but with diagonalized (options in different months) the deeper in the money on the leap, the more the leap acts like the underlying, opening or improving your upside potential. The net negative Gamma for the position is greater than if the long were closer to at the money (gamma for all options is highest at the money and is less the farther away from at the money). However, the downside risk is still very high, because like in a covered call, the risk can still be the entire cost of the long if the underlying's price plummets. The profile gets to look more like a standard short naked put, the deeper in the money the long is.

2. Ratio it: buy more lower same strike leaps than you sell, rather than 1:1. This then becomes a calendarized (or 'time') call ratio backspread. Careful though, since net buying, do so during time when historically speaking the implied volatility of the longs is low. Otherwise, like a long straddle, profits will sag if (and loss may mount) as implied volatility goes lower, especially if the underlying price does not change. Even the expiration curve will be affected as volatility changes, as with all diagonalized (different strikes) time spreads.

3. Diagonally ratio it: Buy leap or in the money leap, buy out of the money higher strike nearer term call, sell out of the money lower strike (but not as low as the leaps's strike) nearer term call.

Both 2 an 3 are analogous to owning stock, and instead of selling a covered call, you have a different premium selling mechanism ... a bear call spread (buy higher strike call, sell lower strike call). This caps risk to that of the bear call spread, like in a standard bear call spread. You'd like the underlying's price to be just below the strike of the short call at expiration.

I might suggest, especially if you don't have much options trading experience already, that you determine the amount of risk you are willing to accept for any one of the originally considered covered call leaps trade, then simply put on a either a same month bear call spread (premium selling spread) or bear put spread (a debit spread), equal to that risk. Otherwise, like covered calls, the strategy of simply buying leap, selling call could have intolerable risk since it can approach the same risk profile as selling a nake put (i.e. high risk).

Also, I suggest that to really see and understand this stuff better, get some option software to see the risk profiles of the different combinations of options, especially if diagonalized. Optionvue is one software to look into, and Optionetics (Plantinum site, web-based, no software to install) is another.
A picture (of risk-reward) is worth a thousand words, and makes it much easier for you to decide what and how you want to trade.

-- Sigsbee

 

Rollovers, etc... don't address the gamma-hole on the LEAPS-side of the spread. It would underperform a CC(short put) portfolio on the upside, outperform on the downside.

A front month calendar spread is not as exposed to vega, and can be traded OTM to reduce the debit. LEAPS are ALL vega, virtually NIL gamma... even with the front month decay -- the LEAPS calendar is simply a large vega(volty) bet.

With the VIX at 12 I would trade the index put calendar; DOTM, and hedge my delta exposure with some ATM calls or futures. Into a decline your OTM put-vols will decrease due to increased moneyness/flattening skew; offset(and then some!) by an increase in the vol-strip:

*** Increase in vol-strip > flattening skew ***

The result is a fair amount of vega and delta/gamma edge(moneyness) from the convergence to strike. Your long call hedge loses on moneyness + skew(drift). The benefit is the limited-loss potential on your upside call hedge.

On the upside; you lose on a drop in the vol-strip, but this is mitigated by a +curvature(skew). Both OTM put calendar and upside call hedge will see a small increase in vols due to increasing curvature/favorable drift..

*** Strip-vol loss =/> increase in position-skew (calendar & hedge) ***

In summary; there is edge in trading long DOTM put calendars hedged with upside long call gamma. I am establishing short-index positions... tomorrow might not be a bad day to go long DOTM put calendars. =)

 

Ratio it. Do it with something you _really_ want to own no matter what. That way you would add to the P/L by selling the out of the money put each month as well.

This strategy works well for people that are a hybrid mixture of traders with an investor mentality, especially in these markets. Looking back, it would have done great in some obvious large cap names. Looking forward, not clear...

nitro

 

i followed terrys tips, a service that sells option premium in many different ways earlier this year. it was a total disaster. almost every strategy lost big money. selling qqq and dia calls against leaps was the worst losing 80-90% in 7 months. i think his problem was trying to guess the direction of the market. as i told him many times if you are able to predict the direction of the market you wouldnt need to use spreads you would just make a straight directional bet. he is out with a new advertising plan to get new customers(victims) and he did talk about what he thinks went wrong. i personally think he still doesnt get it but here is his excuse for losing most of the money:

Negative experience with the Mode Model in 2004:



For the first three months of 2004, the market was in a Green Mode, and the 10K Strategy continued the fine results it had enjoyed in the past. By the middle of March every Auto-Trade portfolio was up over 20%, even though early in March, QQQ had fallen below its 90-day moving average and an Amber Mode was indicated.



Early in April, QQQ crossed its 200-day moving average as well, and we went into a Red Mode, substituting puts for calls (and maintaining a strong bearish position) when new positions were put on. (At this time, we were using puts rather than in-the-money call calendar spreads for downside protection, a policy that proved unworkable in Auto-Trade accounts with only $5000 or less in capital). The market proceeded to go up over 9% and we experienced our first significant losses.



By mid April, the market had re-entered a Green Mode, and we sold our put spreads, moved back into at-the-money and out-of-the-money calendar call spreads to provide upside protection. The market then proceeded to fall about 9%, inflicting losses once again



In early May, QQQ had once again fallen below its 90-day and 200-day moving averages, indicating a Red Mode. We switched back to puts and set up a bearish strategy. The market continued to befuddle us, and rose once again, over 8%. We experienced another 20% losing month, the third in a row.



In June, QQQ went up, kicked off another Green Mode indicator, and we set up a bullish strategy once again. By this time, you can probably guess what happened. The stock fell to new lows for the year, inflicting us with even more losses. (Remember that back-testing had shown that down markets in a Green Mode only occurred one month out of six in the past, and up markets only occurred one month out of six when a Red Mode was indicated. In 2004, these one-in-six scenarios occurred four times in five months.)



As August expiration approached, we decided it was time to step back and review what we had learned. The biggest problem was clearly our Mode Model, which gave several rapid-fire and conflicting directions. We checked back into the recommendations of the half-dozen or so favorite trend-indicating sites we follow to see what would have happened if we had used their composite opinion (in addition to our Mode Model, which does have validity in all but the most choppy markets).



The results were remarkable. We would have switched to a Bear Mode in mid-April and would have stayed in that mode at least until August expiration. While there would have been some losing months, all the portfolios using the 10K Strategy would have been up for the year.



Going forward, we have decided to use a proprietary Composite Market Timing Model to determine General Market Direction. This model consists of our Mode Model as well as the collective conclusions of five other website timing models. We can’t reveal their names as they would not like it (we mentioned one by name to Insiders, and received a letter from them threatening to sue). We selected these five sites because they employed a variety of fundamental, technical, and behavioral indicators to make their recommendations, and because back-testing them revealed that they significantly outperformed the Mode Model by itself, particularly in choppy markets like we have experienced so far this year.



In the future, if you are trading on your own and no longer a Terry’s Tips Insider, the Mode Model may be sufficient for you to determine General Market Direction. However, be wary of switching between Modes until you are certain that there really is a new General Market Direction. If you continue to be a Terry’s Tips Insider, you will always know whether our Composite Market Timing Model indicates a Bull Mode or a Bear Mode.



We concluded that we should give ourselves a new start, and use what we had learned from our losses to move forward with new Auto-Trade portfolios that incorporated our 2004 experience in some slight (but significant) changes to the basic 10K Strategy. This White Paper includes these changes, but we do not dwell on the earlier details that proved to be unreliable.