In my article 'A 'Covered Call' Trade On McDonald's Using LEAPS' I presented a way to trade McDonald's Corporation (MCD). The goal is to reduce the cost of trading while earning some extra money each month. Some people call it a "Covered Call with LEAPS," while the official name is diagonal spread.
The first step would be replacing the stock with a call option 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.
The next step is selling a front month call against the LEAPS. The choice of the strike depends on your outlook for the stock.
One of my fellow contributors Richard Bloch argued that McDonald's might be not the best choice for this strategy because it pays a dividend. He preferred a stock like Apple (AAPL) and even wrote an article 'For Selling Covered Calls, Apple Beats McDonald's'. My response was:
"There is no doubt that AAPL option premiums are much higher than MCD. Looking at Feb. ATM calls, MCD options time value is about 2.2% of the stock value while AAPL time value is about 4.6%. However, I'm not convinced that this makes AAPL a better candidate. The options are more expensive for a reason - AAPL is much more volatile stock. Its behavior is much less predictable. For covered calls strategy, it's better to find a stock with much more predictable and steady growth, and MCD matches the criteria. You prefer the stock to go up 2-3% each month than jump up 5-7% one month and down 2-3% the next month."
So I decided to check who is right.
The Bad Way To Go Long Apple
The following table compares three cases, looking at a one year period from January 17, 2011 to January 20, 2012 (options expiration):
- Buying the stock at 332.68.
- Buying a one year LEAPS (250 Jan 2012 call).
- Buying a one year LEAPS and selling an OTM one month call every expiration Friday.
As we can see, the gains will be as following:
- Buying the stock only: 26.34%.
- Buying a one year LEAPS: 76.62%.
- Buying a one year LEAPS and selling an OTM call: 64.80%.
Turns out that my first instinct was the correct one. A volatile stock like Apple is less suitable for Covered Call strategy. When the stock jumps like it was in July, September and January 2012, selling Covered Calls every month will actually reduce the gains.
If writing covered calls is not the best way to go long Apple, then what is?
The Good Way To Go Long Apple
Obviously you could do very well just by buying the stock. But my goal is to reduce the cost, to increase the gains and to have some downside protection as well. Sounds impossible? How about selling credit spreads, like the one I described here? The trade produced a 42% gain in six weeks. It had 70% probability of success and 7% downside protection.
The following table presents the results of selling a credit spread on expiration Friday every month. The short strikes of all trades have deltas of approximately 0.20, which give the trades about 80% probability of success.
As we can see, all trades would expire worthless. The accumulative non-compounded yearly gain of those trades would be a whopping 238.56%. Each trade had about 80% probability of success and 7-9% downside protection.
Show me another strategy which would produce similar results with such level of safety and caution.
The Ugly Way To Go Long Apple
Well, last year there would be hardly an ugly way to go long Apple. Almost every way would work. However, as I demonstrated in one of my previous Apple articles, buying calls just before Apple's earnings report was, on average, a losing proposition. Apple's weekly calls lost an average of 20% of their value the day after the earnings reports. Some of them lost money even when the stock was up.
I hope you can see the difference between various ways of options trading. Options don't have to be risky and dangerous. It all depends how you play them.