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Take the Leap - Reap the Rewards
Posted by: Dr. Paul Price (IP Logged)
Date: May 18, 2014 07:41PM
LEAP Options: don’t have to last years.
Many traders avoid selling LEAP (Long-term Equity AnticiPation) options because they don't want to be tied up in a trade for one to three years.
Most option traders desire short-term thrills and quick feedback in terms of profit and loss. Smart traders might wish to consider longer-duration options instead, or as well.
The CBOE lists some of the benefits traders may be missing if they pass up using LEAPS as part of their overall investment tool box.
Regular readers of my columns know I trade long-term options regularly. I love the flexibility that one and two year expiration dates give me, especially when selling puts. The longer time frame generates very large time premiums which lower my break-even points significantly.
Those big per share inflows also protect me to a great extent against early exercise even when things don’t go as planned right away. Nobody is likely going to use a LEAP option 10, 15 or 25 months early when they paid big bucks for all that extra time.
Writing for Jan. 2015 or 2016 allows time for earnings growth or other potentially good news to occur. It reduces the need for precision in the timing of your projected uptrend or downtrend in the underlying stock’s share price.
Best of all, selling long-term expirations doesn’t prohibit you from closing out early if you choose to do so.
As the DJIA and S&P were hitting new records recently I was able to take advantage of some nice run-ups in shares that I’d previously sold Jan. 2015 puts on. I closed out eight separate positions on six underlying stocks during the 16-days from April 29, 2014, to May 14, 2014.
My results for that half-month long period are shown below. The oldest of the positions (on Walgreens-WAG) was initiated on June 25, 2013. The most recent were the McDonald’s (MCD) 2015 puts for strike prices of $95 and $100. Those were both sold to open on Oct. 21, 2013.
Note: I use Quicken software to keep my books. With option trades I indicate the number of underlying shares represented, rather than the number of contracts. The dollar amounts are identical.
These trades required zero cash outlays as I used paid-up equity which was already in my margin-type account as the source of the necessary buying power margin requirement (SEC Reg.-T) Regulation T - defined source: Investopedia .
After buying to close (BTC) my net profit on the eight trades was a cool $21,120 after all commissions. At privately-held TradeStation or publicly-traded Interactive Brokers (IBKR) you can trade one option contract for just a $1 minimum commission.
When first sold, the option trades shown had expiration dates that stretched from 15 months to 19 months. The actual time frames from inception through closure ended up ranging from 7 months to about 11.5 months.
People argue all the time about how to calculate ROI (return on investment) when shorting puts. Is it infinite due to the negative cash outlay? Should it be figured as profitability divided by the potential purchase prices had everything been ‘put’ to me? Is it more appropriate to use the final profit divided by the minimum margin requirement?
I will leave that determination for others to argue about. The only thing that matters to me now is that I have an extra $21,120 in cash and all obligations to buy any shares related to those options have disappeared.
Many of the best thing in life are only available to those who have substantial assets. This is true about option selling as well. SEC rules require a minimum $20,000 account value plus approval from your brokerage firm before you can even start the process.
If you qualify and take the time and effort to understand the process, writing puts on stocks you’d be willing to buy can be a great investment technique. Using LEAP options can make it even better.
You can see all the closed-out and current positions in my Market Shadows Virtual Put Writing Portfolio by clicking on the hyperlink. It shows every option trade we've made since we started it up back in January, 2013.
Disclosure: I am short many options,with various short and long-term expirations. These are secured against a well-diversified, value-oriented portfolio of stocks.
Stocks Discussed: SPY, DJI, QQQ,