Options analysis outloud

Failing to Make the LEAP to Long Term Thinking Part Two

A LEAPS debit spread has two forms a calendar spread and a vertical debit spread. It is the vertical spreads which I consider a fantastic tool to add to your options toolbox. For calls you are buying a call option and simultaneously selling a higher strike call option with the same expiration to offset some of the cost, this is also called a bull spread. As the lower strike call will always be more expensive than the higher strike, the net result is a debit. You pay the difference between the two strikes and that amount is your maximum known risk. Debit spreads reduce the volatility compared to buying options. The decrease in volatility works both ways. The spread value will not decline as fast if the stock price falters, but also will not rise as fast in the event of a rally. The objective is for the stock to be above the top leg of the spread, or if puts are used below the bottom leg, as expiration approaches. Be aware that you will also have two different bid/ask prices and two transaction costs.

The three simple rules to help you design winning LEAPS debit spreads.

1. Look for a spread of ten to twenty points between the strike prices, I find 15 works well for most stocks.
2. Aim for a maximum profit of at least 400%
3. Using an options simulator find a spread that has over an 80% probability of success.

A simple rule of thumb for the first two rules is the debit should be 20% of the spread. So if the spread is 10 you want to pay $2, for $15 you’d pay $3. Below is a profit and loss diagram of the trade you’re looking for.

If 80% sounds high to you then consider this. I’m not talking 80% chance of the price being above the higher leg at expiration. It incredibly unlikely you’ll ever find a trade with those odds. You’re looking for a trade which has an 80% probability of the spread doubling some time during the option’s life.

If you find these trades then you need to guard against another danger. Due to the high probability of your spread doubling some time during the trade you may grow overconfident. The danger is you’ll be so confident that you’ll let profits slip right through your fingers. The easiest way to improve your results is to sell half your position if the spread doubles and let the rest ride with a trailing stop. In stock investing I am not a fan of trailing stops or selling my winners, the key difference with options is time. With time working against you trailing stops and locking in profits are sensible tools to ensure your confidence doesn’t cost you. The easiest way to keep this in mind is that you entering a trade with 80% probability of success at some time during the trade, but which may well have less than 50% probability of success at expiration.

More on Using Leaps Options for Long term profits.

Both these guys are trying to get you to subscribe to their newsletters, I don’t recommend them but they have some examples and their free information is worth checking out.

• By Jeff Carter
• By Ken Trester
• Numa.com has the following to say on Bull Spreads

Strategy View Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit, OR Put option is bought with a stike of a and another put sold with a strike of b, producing a net initial credit. Upside Potential Limited in both cases - Calls: difference between strikes minus initial debit Puts: net initial credit Maximum profit if market at expiry is above the higher strike. Downside Risk Limited in both cases - Calls: net initial debit Puts: difference between strikes minus initial credit Maximum loss if at expiry market is below the lower strike. Margin Possibility for margin requirements to be off-set. Read Part One…

Failing to Make the LEAP to Long Term Thinking

Is it possible to find an option strategy that delivers a swing at a home run, an 80% chance of 100% and a known limited risk? You bet it is.

While the old lore that 90% of options expire worthless does not give a true picture of the options market, it is true that buyers generally loose more than they win. Option buyers are speculators. There’s nothing wrong with being a speculator, the important point is to recognise that you are engaged in speculation and to make sure that fits with your personality and risk profile. As a general rule I need to win more than I loose so I don’t often buy options. If you buy options you can loose a lot of the time, but still make money. A few home runs can makeup for a lot of losses.

As predominately an option seller I didn’t get the opportunity for home runs. In fact my losses were sometimes other people’s home runs and those big losses sure ate up a lot of my winners. Just like an insurance company, I collected a lot of premium, but occasionally suffered a big loss. The small speculator in me, never got the reward of those cocktail party stories of option trading glory. It soon became ludicrous to have tor refer back to my SAP home run story of ‘95.

I was always searching for a strategy that could give me a shot at a home run and a high probability of profit.

Then one day I found it, the perfect strategy to add to my options armoury, a strategy that delivered a swing at a home run, an 80% chance of 100% profit and a known limited risk.

Are you mentally screaming tell me, tell me what that amazing strategy is? Maybe you’re screaming it OUT LOUD. Or maybe not, I know I wouldn’t have been. I’m sceptical of most things and the hyperbole surrounding options trading made me wary of such claims years ago. The thing is if you’re an experienced option trader or have any read a few books or followed online discussions then you probably know what this strategy is already. You probably knew it when you read the heading.

Read Part Two….

Believing Writing Covered Calls is Conservative

The entire options industry is setup to convince you selling covered calls is a conservative strategy. If you look at the option trading levels below you’ll see covered call writing only requires the lowest level of option trading approval, level 1. Most brokers and option advisors will recommend you start option trading by writing covered calls. Despite what your broker wants you to believe, I’m here to tell you that writing covered calls is NOT a conservative strategy. Come on say this 21 times with me, Writing Covered Calls is not a Conservative Strategy.

I’m guessing you’re not simply going to believe me without a persuasive argument. Yet you probably believed your broker with no evidence

For my evidence I offer:

1. Look up at the table again. Can you see what trading level uncovered put writing is?
   The second highest level of approval, level 4. Only uncovered writing of index puts and calls requires higher authorisation. Do you find that a wee bit strange? Writing covered calls and uncovered puts are identical option strategies from a risk reward perspective. If they are identical from a risk and reward perspective then why don’t they require the same level of approval? Covered calls is the first strategy most people are “sold” while writing puts is considered an advanced strategy that requires years of option trading experience. Odd, don’t you think?
2. Look at the following profit and loss (risk graph). Is this graph for a covered call or an uncovered put?
   Trick question. There is no way of knowing as the profit and loss, the risk profile, is the same for both. Limited upside and almost unlimited downside. When you sell a covered call you are selling the right to the upside while taking on all the downside risk.
   
   
3. Most people think selling a covered call is giving them some downside protection. The reality is covered calls do not protect the downside. The small downside hedge you receive in selling a covered call is in most cases outweighed by the psychological impact of having sold the covered call. If business conditions change and you should sell the stock, you are more likely to hold the stock rather than sell as your judgement is clouded and confused by the call you sold.

In summary covered calls are not a conservative strategy. They are amongst the riskiest of options strategies and should only be employed under specific circumstances. Covered calls do not protect your downside. They cap your profit leaving you holding all the downside risk and they leave you at the mercy of the market.

Here are my rules for writing covered calls.

1. Only write calls on stocks you own and are comfortable to continue to own.
2. Only write calls at a price you are happy to sell at. This should be your calculation of fair value or some margin above fair value.
3. As stocks generally move in spurts it is preferable to write a covered call after a run up in the price.

My rules when not to sell a covered call.

1. Never sell a call as an exit strategy. Absolutely never ever sell a call as an exit strategy. If a stock has risen to fair value or above and you do not want to own the company for the long term then sell the stock or enter a collar (sell a call and buy a put).
2. Never sell a call to simply to collect a high premium. If a premium looks high there is a reason for it and the downside will bite hard.

Covered calls are a good income producing strategy for long term stock holders. They are not a conservative option trading strategy.

Happy trading
Dean

…you really do NOT need to go out to that furthest dated LEAP right away. Up to a certain point, the time decay on the 2010s will be roughly similar to the 2011s so there really isn’t that much of a benefit to buying the 2011s. Once they start to really diverge, then you just roll forward your 2010s to 2011s. Any interim price action really doesn’t matter much either because the deltas for the same strike price are also going to be roughly similar. It is potentially an additional set of transactions, but if you are right on something like LEAPs the commissions should be negligible.

MDCigan TMF Liquid Lounge

Here is the 2011 Leap schedule from CBOE

• January cycle begin trading on September 15 2008
• February cycle being trading on October 13 2008
• March cycle begin trading on November 17 2008

MDCigan’s thesis that time decay and delta on far out Leaps will be roughly similar and thus the higher cost of the longest dated Leaps is not worth paying for sounds plausible due to the exponential nature of time decay. However, I would like to test this thesis. As the 2009 Leaps are now so close and I don’t have easy access to historical LEAP prices I’ll wait until September to start validating this thesis.

I have spot checked some 2009 Leaps/options in comparison to 2010 Leaps and the theta on the 2009’s were 40%-80% higher, i.e. the time decay on the 2009’s is 40%-80% higher.

As LEAPS Trading points out

It will take a LEAP with 3 years before expiration 273 days before it will loose 20% of its value due to time decay. At 180 days before expiration it will take only 65 days to loose 20% of its value to time decay.

For more on LEAPS check out the CBOE Index Leaps primer.

Option Cycles for Beginners

Options trade in one of three cycles; January, February or March. There are at least four different expiration months available for every stock on which options trade. The stock options cycle determines which months will be available.

JAJO - January, April, July, and October
FMAN - February, May, August, and November
MJSD - March, June, September, and December

The CBOE decided that every stock* would have the current and following month available for trade.

It is June now so every stock* will have June and July options available. Then the option cycle determines what other expiration months are available. January cycles will also have October, February will have August and November while March will have September and December.

The easiest way to tell what cycle of options your stock has is to check the expiration months available. Take a look at Amgen options http://finance.yahoo.com/q/op?s=AMGN

It has June, July and October so it must be a January cycle. Hopefully, you realise it was October that told me that, as all stocks will currently have June and July.

As optionsvueresearch.com states

Option expiration cycles for stocks may seem a bit confusing, but if you take a little time to understand them they become second nature. It can be very important to know what expiration months will become available in the future. Many option strategies require you to make adjustments during the life of a trade, and you need to be certain the contracts you will need are going to be available. Understanding the expiration cycles is just one more way to help you increase your success rate when trading options.

* on which options trade