Selling Short Calls Against Long Calls: Diagonal Spread

Introduction

Covered call writing entails buying a stock and then selling an option.  But what if I buy a call option instead of the stock and then sell a call option on that option? I’ll be spending less money than the outright purchase of the equity and still generate cash from the sale of the call option. Although not a true covered call write, purchasing a long-term option (more than one year out), called  LEAPS, and then selling call options against that position, is an alternate strategy similar to CC writing. Technically, these trades are known as calendar spreads so perhaps we should start off with some definitions.


It's very important to understand that we are in a covered position when buying a deep in-the-money call with a longer duration and then selling a shorter-term call against it.


Advantages of using LEAPS:

  • Less costly than purchasing stock; remaining cash can be used to generate additional cash

  • A declining stock will have time to recover

  • Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar

  • No volatility risk, higher volatility actually benefits a LEAP holder not a common shareholders. It can help offset short-term losses when the market drops

Disadvantages of using LEAPS:

  •  You do not capture stock dividends

  • LEAPs have a levered effect on your returns

Example

We currently have LEAPs on Visa, the $180 calls with an expiration date in June 2022 (having paid 4,000 dollars per contract). We've also sold an equivalent number of short-term calls to reduce our investment little by little and collect time value (which can be re-invested in our largest and phenomenal buy and hold position).


If we do the math, we collected 85 dollars per contract for the $215 short calls expiring on March 6, 2020, meaning we can repeat this transaction around 30 times before the expiration of our LEAPs. That equals to 2,550 dollars in time value along the way, while enjoying plenty of month-on-month upside potential (in this case 9%). In the end, it will have slashed our total investment from 4,000 dollars to 1,450 dollars!


What happened to the cash/profits we generated? We re-invested them into VGP, a wonderful real estate company that recently announced its preliminary results, showing a significant improvement in rental income and net profit. It's already our biggest position, but thanks to the option premiums we can acquire more shares without putting new capital to work. Re-investing your profits in great businesses is the ultimate way to become financially independent.


You can read my articles about VGP, which is listed on Euronext Brussels, on Seeking Alpha.

https://seekingalpha.com/article/4265114-why-vgp-is-largest-holding-interview-company-ceo-jan-van-geet

https://seekingalpha.com/article/4226148-wdp-and-vgp-2-hidden-reits-dividend-hikes-looming

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