Editor's Note: This is Part 2 in a multiple-part series. Part 1 can be found here, Part 3 can be found here, and Part 4 can be found here.

As an improvement on writing covered calls, Steve Smith's article "The Truth About Covered Calls" makes the following suggestion:
 

• Replace the underlying long stock with the purchase of an in-the-money Long-Term Equity Anticipation Security (LEAPS), or long-term call option.
  
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• Rather then selling a single strike call, short sell a vertical spread short for a credit.

I'm using an example that's similar to the covered call position Smith used, but with different strike prices.

My bias is toward writing covered calls that aren't out of the money (I like the better downside protection that comes with writing calls with a lower strike price, even though this reduces the maximum possible profit) and chose to write a call that's closer to being at the money than Smith chose. It doesn't alter the discussion.

I included risk-reward graphs generated by using the online software tool available from Interactive Brokers. It's important to not that you can call these risk graphs, P/L graphs, risk-reward graphs -- it doesn't matter what you call them as long as you use them.

I'm using last Friday's (October 30, 2009) closing prices to generate these examples.

First, let's compare the covered call with the LEAPS version. In Part 3, we'll look at the idea of selling a call spread in place of a call.

Covered call version:
 

• Buy 100 shares of SPY at $103.56
  
  
• Sell (write) one SPY Jan 106 call at $3.35
  
  
• Net debit (excluding trading costs): $100.21 Corrected

• Buy one SPY Dec 2011 90 call at $21.50
  
  
• Sell (write) one SPY Jan 106 call at $3.35
  
  
• Net debit (excluding trading costs): $18.15

Click to enlarge

As I've previously mentioned, the substitution of a long-term option for stock makes a big difference in the results. The downside risk is cut substantially, as can be seen in the graphs.

But, the profits are also limited. In fact, if SPY rises above 135 in this example, the position loses money.

Thus, using a LEAPS option as a stock substitute when writing covered calls isn't as simple as it may seem. It does make the downside better, but the proponents of this idea never talk about the potential upside problems. I don't recommend using LEAPS as a stock replacement when writing covered calls.

***

There's special beauty in the strategy we're going to discuss. I know it's taking me a long time to get to it, but my purpose isn't just to discuss the strategy recommendation, but to write about the steps leading to it, allowing readers to have a better understanding of why the suggested strategy is good (or not so good, depending on your trading style and comfort zone).