Bread and Butter Trade: Buy the Leap, Sell the Call

by: Philip Davis

Phil Davis submits: This is for Ilene, who has patiently waited for me to get around to posting something useful for two weeks: Man does not live on bread alone (although my daughter is game to try), and your portfolio needs variety too.

One of my favorite staples in the portfolio is the income producing (we hope) spread where I buy a LEAP with the intention of selling calls against it each month.

I don't track these because it is mind bogglingly tedious, but the gist of it is we take a leap on a stock, say Sears Holdings Corp. (NASDAQ:SHLD). I like Sears because it's volatile enough to give me a good premium, but good enough that even if it drops to the 200 DMA I can hold on without freaking out, as I think the underlying fundamentals support the stock for the long term.

I'm not looking for a stock that's going up fast, I'm looking for rangy stocks that go up and down in a channel (just like on TV!) so I can sell calls when it's high and buy them out when it's low (although that takes a little practice and nerve!).

We did this with our Google Inc. (NASDAQ:GOOG) plays earlier in the month, but those went up so fast we are going to get called away, so let's go back to Sears!

Right now I think SHLD might make a new high, but I'm also concerned about a pullback so, if I were to go in today, I would want close protection.

The Jan '08 $145s are $39.60 so I'm effectively paying $184.60 for the stock -- a $21 premium. My goal over the next 15 months is to make $1.50 a month to work off the premium. In a regular month, when I'm bullish, I would the sell the Nov $165s for $7.50. That guy is paying a $9 premium for 45 days (sucker!) and I will have no trouble until the stock goes over $174 or under $156.

The proper strategy is to manage this much like any trade and buy your caller out if he loses 70% of his value. You biggest danger in these trades is that, early on, before you recapture some premium, the stock flies up or down on you -- forcing you to take cash out of your pocket for the caller or to liquidate at a loss.

This month I'm in a nervous mood and, as it's a new entry, I will sell the Nov $160 puts for $10.30. This protects me almost all the way to the 50 DMA at $150, and keeps me from going into my pocket under $170. If the stock goes to, say $185 on Nov $17th, I will owe my caller $25, so I will either have to take $15 out of my pocket, or roll the call into the next month at a higher value. In either case, the rise to $185 will likely drive my leap up to $52(ish), which is a nice $12 profit on that end.

If that kind of volatility makes you nervous, try a more stable issue like International Business Machines Corp. (NYSE:IBM). They've been around for 1,000 years and will probably be around for a thousand more (note to self, double check that incorporation date) and, as I complained about in my Dow article, owning them is like watching paint dry.

I really like them because they are kind of down at the moment, probably in the middle of their range, so I would actually take them right now.

The Jan '09 $70s are $20.50, a $7 premium to work off over 27 months. I sell the Oct $85s for .75 as that's a $2.60 premium for 10 days against my .25 monthly premium. See -- I buy low and sell high! The nice thing about IBM is that if it breaks out the Nov premiums will jump up and I can roll into those without giving up any cash.

Genentech Inc. (DNA) Jan '08 $70s are $21 and you can sell the Nov $85 for $2.85.

The New York Times Co. (NYSE:NYT) is in a good spot, but watch out for a breakout following Gannett Co. Inc. (NYSE:GCI) earnings! The Jan '08 $22.50s are $3.10 and the Jan '07 $22.50s can be sold for $1.50.

Intel Corp. (NASDAQ:INTC) Jan '08 $17.50s for $4.70, selling the Jan $20s for $1.70.

The way I book these trades for myself is at the end of each month I take my profit and subtract it from my leap basis. That way I keep track of what I've made on the total trade to date, which helps me make good exit decisions.

I could write a book on this but it would be easier to track a few in comments, so I'll add a couple, but you guys need to remind me to do it otherwise I'll forget. But let's update these on weekends or any time we get a significant move.

I would not initiate any of these positions if the market goes down this week! Remember, your interests are fairly in-line with your callers, you want it to go up -- just not too much!

Read all of Phil Davis's articles on Seeking Alpha.