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McDonald’s Corporation (MCD) has been on a steady rise in the recent years. The stock virtually doubled in the last three years.

In this article, I would like to present a way to reduce the cost of trading MCD while earning some extra money each month. Some people call it a “Covered Call with LEAPS,” while the official name is diagonal spread.

MCD is currently trading at $98.33.

The first step would be replacing the stock with a call option. We will be using a LEAPS (Long Term Equity AnticiPation Security) with one year expiration. We want to replicate the stock movement as close as possible, so we will use DITM (Deep In The Money) option. However, we don’t want to go too deep in order not to pay too much for the option. Looking at January 2013 option chain, we find out that 70 call has delta of 0.86 and is trading at $29.10. That means that for every dollar movement of the stock, the option will move 86 cents. We will be paying for the option only 30% of the price of the stock and the time value is less than $1.00.

The next step is selling a front month call against the LEAPS. The choice of the strike depends on your outlook for the stock. If you think the stock is going to rise, the 100.0 strike would be a good choice. If your outlook is more neutral and you want to be more conservative, then the 97.5 strike is more appropriate. We will examine both cases.

The first trade will be constructed in the following way:

  • Buy MCD January 2013 70 call at $29.10.
  • Sell MCD January 2012 100 call at 1.33.

The cost of the trade is $2,777, less than 30% of the cost of the stock.

Now let’s examine different scenarios at January 2012 expiration.

  1. MCD is unchanged: The LEAPS will be virtually unchanged, the Jan. 2012 call will expire worthless and the trade will be up 4.8%.
  2. MCD is down 3.4% to $95: The LEAPS will be worth around $26.24, the Jan. 2012 call will expire worthless and the trade will be down 5.5%.
  3. MCD is up 1.7% to $100: The LEAPS will be worth around $30.54, the Jan. 2012 call will expire worthless and the trade will be up 10.0%.

The second trade will be constructed in the following way:

  • Buy MCD January 2013 70 call at $29.10.
  • Sell MCD January 2012 97.5 call at 2.58.

The cost of the trade is $2,652.

Let’s examine different scenarios at January 2012 expiration for this trade.

  1. MCD is unchanged: The LEAPS will be virtually unchanged, the Jan. 2012 call will be worth 0.83 and the trade will be up 6.6%.
  2. MCD is down 3.4% to $95: The LEAPS will worth around $26.24, the Jan. 2012 call will expire worthless and the trade will be down 1.1%.
  3. MCD is up 1.7% to $100: The LEAPS will worth around $30.54, the Jan. 2012 call will be worth 2.50 and the trade will be up 5.7%.

As we can see, the first trade offers better upside potential, less downside protection and slightly less return if the stock is unchanged.

At January 2012 expiration, you can repeat the process and sell the February option. Sometimes after a few months you can own the LEAPS for free.

As with any trade, those trades are not without risks. Trading options, we are reducing the cost using leverage, and leverage works both ways. If the stock is down more than 5%-7%, the losses will be magnified. MCD was up 3%-4% per month on average in the last few years and was rarely down more than 4%-5% in a month, but anything can happen.

If you still have a positive long-term outlook for McDonald’s, this might be a good way to trade it.

Source: A 'Covered Call' Trade On McDonald's Using LEAPS