“Covered calls on Apple (NASDAQ:)” was the theme we in detail last week. In the earlier post, we noted that buying 100 shares of Apple would cost around $13,500, a considerable investment for many people.
Some investors prefer to put together a “poor person’s covered call,” on the stock instead. Therefore, today we introduce a diagonal debit spread on Apple, which is sometimes used to replicate a covered call position at a considerably lower cost.
Investors who are new to options might want to-revisit last week’s article first (link above), before reading this one. For many readers, today’s piece should help increase their understanding of options. For more experienced investors, it is likely to offer ideas for future trades.
First, let’s take a look at LEAPS options.
LEAPS stands for “Long-Term Equity Anticipation Securities.” Readers might also see websites referring to them as LEAP options or LEAPs.
Investors who believe in the long-run growth potential of underlying assets, like stocks or exchange-traded funds (ETFs), could consider using LEAPS options, which are long-dated, usually one to two years till expiration.
Investors like LEAPS as they “cost less” than stocks, i.e., they’re 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 expiry dates by which the “predicted” move should play out.
As they are long-term investments, participants have quite a long time (i.e., around two years, depending on the chosen option) to follow the moves in the price of the underlying security. Nonetheless, they still expire and the trader could lose all the capital invested if the expected move does not materialize.
Therefore, before jumping into LEAPS, an investor should be clear about their hedging requirements or speculative objectives. Within their risk/return parameters, they should understand how these long-dated options can help.
Those investors who would like to learn more about trading strategies with LEAPs can refer to the educational websites of the Options Industry Council (OIC), Cboe Global Markets or the Nasdaq Exchange.
A Diagonal Debit Spread On Apple Stock
Current Price: $136.91
52-Week Range: $53.15 – $145.09
1-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 shorts the other one to make a diagonal spread.
In this LEAPS covered call strategy, both the profit potential and risk are limited. The trader establishes the position for a net debit (or cost). The net debit represents the maximum loss.
Most traders entering such a strategy would be mildly bullish on the underlying security—here, Apple.
Instead of buying 100 shares of Apple, the trader would buy a deep-in-the-money LEAPS call option where that LEAPS call acts as a “surrogate” for owning the AAPL stock.
As we write, Apple is $136.91.
For the first leg of this strategy, the trader might buy a deep in-the-money (ITM) LEAPS call, such as the AAPL Jan. 20, 2023, 100-strike call option. This option is currently offered at $47.58 (mid-point of the current bid and ask spread). In other words, it would cost the trader $4,758 instead of $13,691 to own this call option that expires in slightly less than two years.
The delta of this option is 0.80. Delta shows the amount an option’s price is expected to move based on a $1 change in the underlying security.
In this example, if AAPL stock goes up $1, to $137.91, the current option price of $47.58 would be expected to increase by 80 cents, based on a delta of 0.80. However, the actual change might be slightly more or less based on several other factors that are beyond the scope of this article.
So an option’s delta increases as one goes deeper into the money. Traders would use deep ITM LEAPS strikes because as delta approaches 1, a LEAPS option’s price moves begin to mirror that of the underlying stock. In simple terms, a delta of 0.80 would be like owning 80 shares of Apple in this example (as opposed to 100 in a regular covered call).
For the second leg of this strategy, the trader sells an out-of-the-money (OTM) short-term call, such as the AAPL Mar. 19, 2021, 140-strike call option. This option’s current premium is $4.30. In other words, the option seller would receive $430, excluding trading commissions.
There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point in this trade.
Different brokers or online websites might offer “Profit & Loss Calculators” for such a strategy. Calculating the value of back-month (i.e. LEAPS call) when the front-month (i.e., the shorter-dated) call option expires requires a pricing model to get a “guesstimate” for a break-even point.
Maximum Profit Potential
The maximum potential is realized if the stock price is equal to the strike price of the short call on the expiration date of the short call.
In other words, the trader wants the Apple stock price to remain as close to the strike price of the short option (i.e., $140 here) as possible at expiration (on Mar. 19, 2021), without going above it.
In our example, the maximum return, in theory, would be about $677 at a price of $140.00 at expiry, excluding trading commissions and costs.
How did we arrive at this value? The option seller (i.e., the trader) received $430 for the sold option.
Meanwhile, the underlying Apple stock increased from $136.91 to $140. This is 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 in theory increase by $309 X 0.80 = $247.2 (However, in practice, it might be more or less than this value).
The total of $430 and $247.2 comes to $677.2.
Therefore, by not investing $13,691 initially in 100 shares of Apple, the trader’s potential return is leveraged.
Put another way, the premium the trader initially receives for selling the shorter-dated call option (i.e., $430) represents a higher percentage of the initial investment of $4,758 than if the trader bought 100 shares of Apple outright at $13,691.
Ideally, the trader hopes the short call will expire out-of-the money (worthless). Then, the trader can sell one call after the other, until the long LEAPS call expires in about two years.
Active position management in a diagonal debit spread is typically more difficult for novice traders.
If Apple is above $140 on Mar. 16, then the position will make less than the potential maximum return as the short-dated option will start losing money.
Then, the trader might feel the need to close the trade early if the Apple price shoots up and the short call gets caught deep ITM. In that case, the trader might need to close the entire trade and start over, or put together alternative option strategies.
In a regular covered call, the trader might not necessarily mind being assigned the short option as s/he owns 100 shares of Apple as well. However, in a poor person’s covered call, the trader would not necessarily want to be assigned the short call as s/he does not actually own those AAPL shares, yet.
On Mar. 16, this LEAPS covered call trade would start losing money if the Apple stock price falls to about $132 or below. In theory, a stock’s price could drop to $0, decreasing the value of the long call with it.
Finally, we must also remind readers that deep ITM LEAPS options tend to have high bid/ask spreads. Therefore, every time the trader buys or sells such a LEAPS option, there could be a significant transaction cost.