LEAPS Trading Strategies

Powerful Techniques for Options Trading Success

Marty Kearney

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118538852
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Investors are increasingly turning to LEAPS (Long-Term Equity AnticiPation Securities) to combine the advantages of options trading with the benefits and security of a longer time frame. Here, Marty Kearney of the Options Institute at the Chicago Board Options Exchange examines the wide range of practical and effective strategies for managing LEAPS, and shows you how to match these strategies to your own risk profile.

Learn how to tailor your options program using LEAPS and devise key strategies to improve profitability, protect paper profits, and avoid losses in long stock positions.

• Use LEAPS to produce monthly income
• Identify key elements in determining LEAPS prices
• Master LEAPS symbols and expiration cycles
• Insure your portfolio against market pullbacks
• Manage year-end tax consequences
• Establish security positions with little risk

Kearney walks you through the inner workings of LEAPS and shows you compelling strategies for incorporating them into your overall approach to market. With instant access to the online video, you'll have everything you need to begin profiting with LEAPS.

Chapter 1

A BRIEF REVIEW OF THE BASICS

I want to begin by going through the primary attributes of the LEAPS option, and explain how these are distinguished from better-known listed options.

If you read the introduction, then you’re already familiar with the rules of the game: calls and puts. Now we need to cover the basics of all options. These concepts and definitions are mandatory before we proceed, so let’s get started.

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LEAPS is an acronym for Long-term Equity AnticiPation Securities.

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IMPORTANT TERMS

Before proceeding to a discussion of LEAPS strategies, there are a few terms that are important to master.

• Strike price
• Exercise/Assignment
• Premium
• Expiration

Strike Price

The first and most distinguishing feature of LEAPS options is the strike price. Every option is an intangible contract granting rights to buyers and placing obligations on sellers. All of the valuation of those terms, and ultimately of the LEAPS option itself, are based on the strike price, the level at which the contract takes effect.

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Every LEAPS has a fixed strike price—the price at which the call or put can be exercised.

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Every option is specifically related to an underlying security, usually a stock, ETF, or index. For example, if you buy Wal-Mart calls, they cannot be transferred to JCPenney or Sears. They are, and will always be, Wal-Mart calls. Strike price is the price per share at which that option can be exercised. As an example, let’s say that you purchase an XYZ January 40 call at $2.25. If XYZ goes to $60 per share, the 40 strike call is $20 in-the-money (ITM). When an option is in-the-money, the current price of the underlying stock is higher than a call’s strike price, or lower than a put’s strike price. If XYZ fell to $30 per share, the 40 strike call would be considered $10 out-of-the-money (OTM). An option is out-of-the-money when the current price of the underlying stock is lower than a call’s strike price, or higher than a put’s strike price.

Exercise/Assignment

When an owner exercises a call, he or she is able to buy 100 shares at the strike price, even if current market value is much higher. When an owner exercises a put, he or she is able to sell 100 shares at the strike price, even if the current market value is far lower.

ITM LEAPS options can also be exercised (by owners of the options) or assigned (to investors who have sold the option) before expiration. This happens rarely, as long-term options usually have time premium embedded in the options price. When options are exercised, the Options Clearing Corporation assigns the exercised option to one of those sellers, either on a first-in, first-out basis or, usually, on a random basis.

Premium

The price of an option is called the premium. It is made up of two components, intrinsic value (how much the option is in-the-money) and time premium (the difference between the option price and its intrinsic value). If XYZ is trading at $60, and the 40 strike call is trading at $24 (the premium), $20 of that is intrinsic value and the other $4 is time premium. The further ITM the option goes, the greater the value of the option should be. Premium is the value per share, and because every option refers to 100 shares of stock, you have to read the quote properly. When you see that an option is worth 2, that means $200; if a LEAPS option is quoted at 4.35, its dollar value is $435.

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The premium is the market value of the LEAPS, which rises and falls as the underlying security’s value rises and falls, and as expiration nears.

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Expiration

Another attribute of the LEAPS option is expiration. Every option expires at some point in the future. As expiration gets nearer, the likelihood of exercise increases as well, especially when the underlying security’s market price is higher than the strike for calls, and when the underlying security’s market value is lower than the strike for puts. Once the expiration date passes, all of the options pegged to that expiration cease to exist.

Distinctions also have to be made between LEAPS options and the more traditional, shorter-term listed options. First, LEAPS options exist up to 30 months, which is an incredibly long time when compared with the lifetime of eight months or so for non-LEAPS options. Because LEAPS options last beyond the current 12 months, the ticker symbols for LEAPS options are more complex than for traditional options. As dates get closer, specific strike prices and expiration times become more important. Overall, because of their longer-term option contracts, LEAPS offer a range of practical strategies.

So, let’s sum up what we’ve learned about LEAPS so far:

• LEAPS are Long-term Equity AnticiPation Securities
• Can have a lifetime of up to 30 months (2 ½ years)
• Because of their length, they require different ticker symbols
• Many practical strategies can be applied to trading LEAPS

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All LEAPS are going to expire in the future. Unlike shares of stock, which never expire, LEAPS have a limited life. This fact directly affects premium value.

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DIFFERENCES: SECURITIES VERSUS OPTIONS

Although LEAPS share the same trading rules and attributes as traditional options, they are actually more like stocks. This is because they have lifetimes up to 30 months. The duration of a LEAPS contract is important because it is treated as a security (thus, the name Long-term Equity AnticiPation Security). But they are also conversion securities. This means that the closer the time gets to expiration (the third Friday of the expiration month/year), the more a LEAPS starts to act like a traditional option. In their last nine months, LEAPS options behave more and more like traditional, shorter-dated options. This distinction is important only in an esoteric sense. As you will see later, strategies for trading LEAPS are really identical to those you would use for three, six, and nine month options, but the time frame is far longer. This provides you with more flexibility and often presents you with better pricing bargains and returns. Keep in mind, however, that LEAPS options—whether you think of them as securities or options—act like the old-style options and are used in the same ways to speculate, hedge, insure, or take profits on long positions.

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See that word “security”? LEAPS are not options, they are securities. To see this explained, log on to www.traderslibrary.com/TLEcorner.

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A BRIEF HISTORY OF OPTIONS

The trading of standardized, listed options began in 1973 with the founding of the CBOE, the first U.S. options exchange1. In the beginning, these options used to be simple to track because their expiration month never exceeded a year. (Expiration month is the specific month when options expire.) So September options always expired the third Friday in September, and December options always expired the third Friday in December. Technically, it’s the Saturday following the third Friday of the month, but “expiration friday” is the common usage.

As options gained popularity, it soon became apparent that both the floor traders and individual investors preferred to trade or hedge for shorter terms. So, the original rules were modified and the CBOE decided that every stock would always have the current month plus the following month available to trade.

Every option you can think of now has options in the next two months as well as in their expiration cycle of three, six, and nine months. Every traditional option trades on one of three cycles: JAJO (January, April, July, October expirations); FMAN (February, May, August, November expirations); and MJSD (March, June, September, December expirations). So for listed options, you’ll find contracts that expire in the next two months as well as those expiring in the coming months of their expiration cycles.

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Expiration cycles and months used to be quite limited; today, option traders have more variety and flexibility, not only in the duration of options, but also in the frequency of expirations.

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Then, traders asked: “Well, it’s nice to be able to trade in the immediate one or two months, but if we can go out nine months, why can’t we have a product that goes out further?” So LEAPS evolved to address that. On October 5, 1990, the CBOE introduced LEAPS to supply investors’ demand for options with longer-term expirations. Because LEAPS appealed to both options and stock traders, they proved successful from the start2.

Currently, on the U.S. exchanges that trade options, there are about 2,800 stocks on which you can trade options. Unfortunately, only about 900 of those stocks also offer LEAPS, so not every stock has long-term options. “What?” you might be asking. “Only one-third of the stocks have LEAPS? Which ones?” Well, the stocks that are in the news—the stocks that trade, such as IBM, Microsoft, QQQQ, and Intel, for example.

Today, LEAPS extend as far as approximately two and a half years. They can technically go out 39 months, but at this point, 30 months is the longest duration you will find.

OPTIONS SYMBOLS3

U.S. options trading symbols tell us four important things about the option: what the underlying stock is, whether the option is a call or a put, the option’s expiration month and its strike price, all in just a few letters. To help you understand, let’s break down an option ticker symbol into three parts.

• The first two to three letters of an option ticker make...