Options Education

LEAPS

LEAPS (Long-Term Equity Anticipation Securities) are long-term call or put options that have expiration dates that are one year or more in the future. There can be as much as two-and -a-half years left until expiration. LEAPS are used as a stock substitute and have a very similar risk/reward profile. Like standard stock options, each LEAPS contract represents 100 shares of the underlying stock. All LEAPS contracts have January expiration dates.

Long-Term Bullish and Slightly More Aggressive Than Stock Ownership

Suppose we are friends with one of the greatest car restoration specialists in the world. One day he takes you in the back of his shop and uncovers a Mercedes Gull Wing. He is going to start work on it in a couple of weeks, and figures that it will take about two years to finish. You've always loved the old Gull Wing so you decide to put a deposit on it and make a contract with your friend.

You know the quality of your friend's work and believe this car will bring a handsome price when it is completed. You lock in your right to buy the car at the current market value for restored Gull Wings with the anticipation that in two years Mercedes Gull Wings will be in even more demand than they are today. This is the mindset for a LEAPS play.

LEAPS can be an ideal investment instrument for the option trader who expects significant long-term growth in an underlying stock but who does not want to make the substantial capital outlay required for entering a long-term position in the stock. With expiration dates set many months or even years in the future, time decay occurs very slowly for LEAPS, so buying LEAPS is an effective way to benefit from a stock's price movement without incurring the risk associated with an outright stock purchase.

LEAPS are option strategies that find their place between aggressive, short-term option trading and an outright purchase of the stock. It is much more profitable to use the short-term trading strategies if a stock is expected to move soon. If, however, the time horizon calls for a longer holding period and you want a leveraged way to play a stock without committing a lot of money, LEAPS may offer the most profitable strategy.

The argument can be made to buy stock on margin, rather than using a LEAPS contract. But some of the benefits of purchasing LEAPS contracts instead of stock on margin include no possibility of a margin call and no interest expense for borrowing from our broker.

Rules for LEAPS

The stock must be a fundamentally sound stock. This should be common sense to most investors, but because of the long time frame the stock must have good fundamentals to rise in value.

It is advisable that LEAPS be purchased when the general market indices are in a bullish trend. Due to the long time frame of a LEAPS contract this will usually be of most significant influence. To help determine if the general indices are in an uptrend, check to see if the broad market indices are above the 200-day moving average and that the average is in a slight uptrend. You won't be perfect all the time, but this is often a good way to determine the likelihood of a bull market. What are the general averages? The general averages consist of the Dow Jones industrial average ($INDU), the S&P 500 index ($SPX) and the NASDAQ composite ($COMPQ).

Purchase LEAPS that offer the best risk reward ratio. Delta is the correlation between the stock price movement and the option price movement. When buying LEAPS, ideally we are looking for a 1:1 ratio or a Delta of 100%. This means that when the stock rises $1 in value, the LEAPS option will also rise $1 in value. This is ideal, but when balancing the risk reward ratio, the ideal has some drawbacks. It is only the extremely deep ITM LEAPS that have a delta close to 100.

By purchasing EXTREMELY deep In-the-Money LEAPS we decrease our risk, but we also decrease our potential for greater reward because the LEAPS will be so expensive. Buying ATM LEAPS for the best risk /reward potential means the cash outlay is lower and the delta is acceptable. ATM LEAPS options usually have a delta of between 40 and 60, meaning that the ATM LEAPS will increase in value 40 cents to 60 cents on every dollar rise in the stock. Of course as your contract moves deeper In-the-Money, the delta will increase and you will participate in a greater gain for each dollar move of the underlying.

LEAP Rules

• A fundamentally great stock
• Industry and general markets in up trends
• Buy ATM or ITM LEAPS

If you will follow these rules, it decreases the risk one more notch so that you are almost as conservative with this strategy as you would be with buying stock outright. One still has a bit more risk than buying the stock, but the rewards and benefits far outweigh the slight more risk scenario.

When purchasing LEAPS as a substitute for stock ownership you increase your potential return. Through the use of leverage you increase your returns while having the advantage of less cash outlay.

We need to take a more specific look at the benefits of leverage. First, when buying LEAPS, it requires less capital outlay. If you spend less money, you will naturally have less at risk. This is a dramatic benefit with LEAPS. This is the real advantage that we are looking for with LEAPS. We want the leverage of options, the risk of stock, without paying margin interest.

Some Other Points to Consider

• If the underlying stock pays a dividend, you will not be eligible to collect that dividend when owning a LEAPS contract
• Due to the fact that LEAPS are options, there is a risk that the option will expire worthless
• If you would not buy the stock outright, do not buy LEAPS calls
• If you are considering purchasing LEAPS call, you should be confident that the broad market trends are bullish

The "Collar" Strategy

Neutral or Protective Option Strategy

Another protective option strategy that is frequently used is the "Collar." This strategy is designed to help you protect unrealized profits on optionable stocks that you already own. Collars can also be a great way to protect your potential stock profits while you're on vacation, or otherwise unable to closely monitor your stock positions without the need for stop-losses.

Here's how a collar works:

Suppose that you purchased at least 100 shares of an optionable stock with a bullish expectation over the short- to mid-term. As the shares gain value, you expect that the stock will continue to rise, but you're not quite ready to sell yet. Now you're ready to go on vacation, and want to make sure that your position is protected.
How? You first sell a Call contract for every 100 shares of the stock that you own one to two strike prices out of the money one month from expiration. You then take the profit from the Calls that you sold, and buy the same number of Put contracts one to two strike prices out-of-the money. This combination enables you to go on vacation free of worry that your stock position will be protected. The total out of pocket for this protection is relatively low, often limited to the trade commissions themselves. Sometimes the premium you make from selling the Calls can more than offset the cost of the Put contracts. Here's the advantage: If the stock rises in price, the Covered Calls are exercised, The Options Clearing Corporation sells your shares, and you receive the strike price per share for the shares sold.

Here's the advantage:

If the stock drops in price, the loss in value of the stock is at least partially offset by the increase in value of the Put contracts.

• Sell Out-of-the-Money Calls one or two strike prices out-of-the-money, selling enough contracts to cover the number of shares you own in the underlying stock
  
• Buy One or Two Strike Price Out-of-The-Money Puts matching the number of calls you sold
  
• If the stock goes up, your calls are exercised, you receive the strike price (per share) of the options in return for your shares
  
• If the stock price falls, your loss in stock value is at least partially offset by the increase in value for your Put contracts
  

Strategy Advantages:

With a Collar trade in place, you can take comfort in the knowledge that you have protection on your shares regardless of market direction, and without the need to place stop-losses.

Strategy Limitations:

Since you have a limited upside potential due to the sale of the covered call contracts, and since a drop in stock price is likely to be only partially offset by the increase in value of the Put option (the Delta for the one strike price out-of-the-money Puts will be less than 1.00), this is essentially only a "maintenance" or neutral strategy.

Exchange Traded Funds (ETF) and Index-Tracking Stocks

Based on our overall market assessment, we can now search for investments that fall in alignment with our forecast. Or, we can elect to play the broad markets. In the past, the only way to play the broad market was through an index or a fund. The problem with indices was the only way to play them was by buying and selling options (which can be quite risky when dealing with indices). And, funds have buying and selling limitations, as well as fees associated with them.

Those constraints have now been alleviated with the advent of exchange traded funds (ETFs) and index-tracking stocks. As the name suggests, these are stocks that track or follow an index and you can buy them and sell them just like a stock. With approximately 70% to 80% of all fund managers underperforming the market indices, some Wall Street sages believe that these powerful instruments may make mutual funds obsolete someday. Hyperbole aside, however, ETFs are certainly a powerful investment vehicle.

The Growing Number of ETFs

There are over 100 ETFs, and as discussed these powerful vehicles give us the opportunity to participate in broad market and index movements. They have been designed to have many of the properties of a fund without the fees and restrictions. For example, the illustration demonstrates the tracking abilities of ETFs, QQQQ compared to the NASDAQ.

ETFs also allow us to trade a basket of stocks without having to build the basket ourselves. Below is the an ETF that tracks the biotechnology index. The only way to invest in this index is if we elect to buy or sell options. However, with the biotechnology ETF we can buy and sell it just like a stock and if we decide to short it we do not have to wait for an uptick. Furthermore, several ETFs also have options available on them, including this one.

Using ETFs is a great way to invest in the broad markets, certain sectors, as well as more specific indices (i.e. semiconductor, biotechnology, etc.).

The Sectors

The next step in our broad market analysis after assessing the major market indices will be to analyze the sectors.
Stocks are divided into broad categories called sectors.

Basic Materials Capital Goods Conglomerates Consumer Cyclical Consumer/Non-Cyclical Energy

Financial Healthcare Services Technology Transportation Utilities

As we examine the sectors it can give us an indication of where money is flowing in and out of certain areas of the market. If we are bullish we will look for the best performing sectors. When we are bearish we will look for the poorest performing sectors.

Sector Analysis

Several sources are available to find the best and worst performing sectors:

• Research Hub gives sector ratings including slightly outperform, market performer, slightly underperform, and underperform.
• ETF Hub and Quote Detail has sector performance tables and charts.
• Screener based on your search criteria gives the best and worst ETFs.

Based on our forecast we can elect to dig deeper and find the top performing stocks within that sector or focus on that sector and take advantage of its strength or weakness by utilizing an ETF.

Industry Analysis

As we migrate through our top-down approach, the next stop is at the industry analysis. Thinking back to the breakdown of the market, remember that sectors are divided into industries. After we discover which sectors are our best or worst performing, we can then find the top or poorest performing industries in those sectors depending on our motives and our forecast.
In order to compare the relative strength of the Industries within the OptionsXpress system, simply When looking at relative strength, we are essentially looking for the strongest performing stocks based on our market forecast. Using this approach will allow us to find the stocks that will provide us with the best opportunity for finding success.