Steve, I enjoy your articles about options, as I'm trying to learn about them. For the past three years, I have been writing covered calls on Dell (DELL) - Get Report stock with the following strategy: I sell LEAPs when Dell is at the high end of its range, then buy them back when the stock falls to the lower end of the range. I repeat this cycle throughout the year.I've made decent money doing this, but I've often wondered if my strategy is the most profitable way to use options, or if there is a better way. My broker seems to prefer dealing with short-term options, but I've always been able to make more with the LEAPS. They seem to fluctuate more in price, giving me a bigger profit. I would be interested in your thoughts about my strategy. -- L.P.
Before I hedge my answer by giving the speech about how there's no one way to trade, the flexibility of options, and that the most profitable way is the one that works for you, I'll try to quantify and compare the annualized returns of writing LEAPs vs. writing shorter-dated calls. That way you can make a better decision regarding what strike to sell.
The first thing we need to do is remove as many variables as possible, starting with any price change in the underlying security. To the reader I'll say this: Including your trading acumen and ability to sell the highs wouldn't be fair or repeatable in projecting potential returns. In the table below, I'll assume that you always sell the nearest-to-the-money calls and that the implied volatility stays constant for each strike.
The table compares the prices of two Dell $30 calls, one with 30 days and one with 10 months until expiration. I'm using the current implied volatility of 38 for the front month and 41 for the LEAP, and the stock's Thursday closing price of $28.67. The Black-Scholes pricing model is the pricing method.
Clearly, in this instance, selling the short-dated options produces superior returns given my assumptions. While the absolute return numbers will vary widely from the example above, and you should always check the numbers on a case-by-case basis, I'll tell you that 95% of the time selling the front month on a rolling basis will result in higher returns.
The simple explanation is that the time decay of an option's premium value accelerates as the option approaches expiration. This is known as an option's theta. All else being equal, selling a short-dated option will allow you to capture the steep part of the time decay curve 12 times a year rather than once (give or take a few months) using LEAPs.
Of course, in the real world the stock price won't remain stagnant, and selling a call for 75 cents doesn't afford you much downside protection. If you're looking to lock in gains, a longer-dated further-in-the-money call might be appropriate.
Other things to consider include your market opinion and timing, commissions and the option profile for each specific situation.
So, even though it's one of the most popular and straightforward options strategies, covered call writing still presents the investor with a variety of choices and decisions to make. And like all investment decisions, the path you choose will depend on your style of trading, expectations, goals and risk tolerance.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to