Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.

Calendar Call Spreads

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With the nuclear threat in Fukishima, Japan earlier this month, stocks like Cameco (CCJ) have taken a big hit.  CCJ has come down in price from $43.59 in February 2011 to its current $30.08.  However, that is just one nuclear plant (or group of plants) among many more throughout the world.  I believe that the selloff is overdone, and expect the stock to resume its uptrend.  To that end, I will create a Calendar Spread, where I will buy LEAP call options, and sell nearer-term call options against them.  Here is the play: I will go to 2013 and purchase the LEAPS for CCJ 35 strike price.  That's a 16% increase over its current price.  I fully expect CCJ to increase by the necessary 16% between now and January 2013.

Buy 2013 35 calls @$4.54

Sell May 2011 35 calls @$.44

Net DEBIT $4.10.

Here I am attempting to amortize the cost of the LEAP calls by selling calls against them.  With a cost basis of $4.10 and 21 months to expiration of my LEAPS, the monthly cost of those LEAPS comes to $0.195 per month.  In other words, in order to recoup my total initial outlay, I will have to get a minimum of $0.195 per month every month until expiration.  Of course, not every month will produce a sellable opportunity against those LEAPS.  The idea is to get much more than the minimum $0.195 per month, and thus make a profit.  The return of $0.44 represents a 9.69% return on my investment ($0.44/$4.54).

If the stock increases in price as expected, I can sell higher-strike price calls monthly against my long LEAPS.  The monthly "covered" calls do not have to be at the 35 strike; they can be at any price.  If I sell a strike below $35, I will be creating a Bear Calendar Spread; if above $35, the spread will be a Bull Calendar Spread.

Ideally, I would wish for CCJ to increase in price beyond $35.  As the price increases, so do the underlying long LEAPS (provided there is enough time to expiration, that is).  Currently, the $35 LEAPS are pure time value.  But if CCJ rises to, say, $40, with enough time before expiration, those LEAPS should rise geometrically, thus producing significant profit.  I'll keep you posted.

Buying to Close (BTC)

On 4/20/2011, I bought to close the May 35 calls for $0.05.  Recall that when I initiated this trade, I sold the May 2011 35 strike call options for $0.44 to reduce my cost basis on the 35 LEAPS to $4.10.   By buying those calls, I accomplished two things: (1) I withdrew my obligation to sell CCJ at 35; and (2) I made a profit on the sold calls, to wit: $0.39 per share, or $195 in cold cash.  This represents 8.59% on my original investment of $4.54, or 88.63% return on the calendar call portion ($0.44/$0.05=$0.39).  My cost basis on the LEAPS is now $4.15.

On 5/04/2011, I sold to open (STO) the Sep. 2011 35 calls for $1.30.  That brings my break-even cost down to $2.85.