40 lines
3.1 KiB
Plaintext
40 lines
3.1 KiB
Plaintext
Chapter 25: LEAPS 393
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The larger premium of the LEAPS call that was written produces this dramatically
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lower break-even price for the LEAPS covered write.
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Similar comparisons could be made for a covered write on margin if the investor
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is using a margin account. The steps above are the mechanical ones that a covered
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writer should go through in order to see how the short-term write compares to the
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longer-term LEAPS write. Analyzing them is often a less routine matter. It would
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seem that the short-term write is better if one uses the annualized rate of return.
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However, the annualized return is a somewhat subjective number that depends on
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several assumptions.
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The first assumption is that one will be able to generate an equivalent return six
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months from now when the July 50 call expires worthless or the stock is called away.
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If the stock were relatively unchanged, the covered writer would have to sell a 6-
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month call for 4 points again six months from now. Or, if the stock were called away,
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he would have to invest in an equivalent situation elsewhere. Moreover, in order to
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reach the 2-year horizon offered by the LEAPS write, the 6-month return would
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have to be regenerated three more times (six months from now, one year from now,
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and a year and a half from now). The covered writer cannot assume that such returns
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can be repeated with any certainty every six months.
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The second assumption that was made when the annualized returns were cal
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culated was that one-half the return if exercised on the LEAPS call would be made
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when one year had passed. But, as has been demonstrated repeatedly in this chapter,
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the time decay of an option is not linear. Therefore, one year from now, if XYZ were
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still at 50, the January 50 LEAPS call would not be selling for half its current price
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(½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors
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remained unchanged. However, given the variability of LEAPS call premiums when
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interest rates, volatility, or dividend payouts change, it is extremely difficult to esti
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mate the call price one year from now. Consequently, to say that the 21.5% 2-year
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return if exercised would be 10.8% after one year may well be a false statement.
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Thus, the covered writer must make his decision based on what he knows. He
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knows that with the short-term July 50 write, if the stock is called away in six months,
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he will make 6.9%, period. If he opts for the longer term, he will make 21.5% if he
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is called away in two years. Which is better? The question can only be answered by
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each covered writer individually. One's attitude toward long-term investing will be a
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major factor in making the decision. If he thinks XYZ has good prospects for the long
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term, and he feels conservative returns will be below 10% for the next couple of
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years, then he would probably choose the LEAPS write. However, if he feels that
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there is a temporary expansion of option premium in the short-term XYZ calls that
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should be exploited, and he would not really want to be a long-term holder of the
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stock, then he would choose the short-term covered write. |