So I actually want to specify that this series is specific to call options to buy on companies that are a going concern. This would not include distressed equities or companies in the special situations arena (spin-offs, mergers, etc.). This also does not include times it may be appropriate to write call options (I'll address that in another series).
So after reading Part 1, we agree that the first thing we do is run a screen for undervalued companies. Of these companies, we filter for those which have LEAPs trading. So, what's left to decide?
Let me say outright, that a perfect option would have the following characteristics:
1.Underlying stock undervalued, the more the better
2.Long dated expiration
3.Low implied volatility
4.Low current interest rates
(Until recently, I did not realize how much more important #4 is for LEAPs than for shorter term options. Options as a Strategic Investment explains this well.)
So, then we are left with the question of what strike price to buy. Strike price is a tricky subject, essentially because you have something to lose and gain regardless of whether you pick a higher or lower strike price.
The more out of the money the strike price, the less capital you tie up per option. This translates into cheaper deltas, i.e., you can buy more deltas with the same amount of dollars ([delta/$] is essentially a measure of leverage; the delta value of an option is the proportional change in the option price for a $1 change in the stock price). The temptation, of course, is to load up on far out of the money options, in the hope of getting a >100% windfall. This, of course, is not the typical behavior of a value investor, but rather a speculator. The problem with far out of the money options, then, comes from the increased probability that they will never reach the strike price and expire worthless.
The deeper in the money the option, the more capital you tie up per option. This translates into less leverage and depending on how expensive the underlying equity is, may make buying even a single LEAP an unreasonably large percentage of your portfolio. Of couse, on the other hand, deep in the money leaps behave more like the stock, and are much less likely to expire worthless.
So that leaves us with LEAPs which are near the money, either in or out. Specifically, in the next part of the series I will address the different ways that you can look at options within two strikes of the current price, and determine which ones are the best investment.
To recap the option screen:
1. Underlying stock at least 25% undervalued.
2. LEAPs available.
3. Options strike price 2 above and below the current price.
If you liked this article, please rate it.
Please visit my blog, The Doctor Investor
So after reading Part 1, we agree that the first thing we do is run a screen for undervalued companies. Of these companies, we filter for those which have LEAPs trading. So, what's left to decide?
Let me say outright, that a perfect option would have the following characteristics:
1.Underlying stock undervalued, the more the better
2.Long dated expiration
3.Low implied volatility
4.Low current interest rates
(Until recently, I did not realize how much more important #4 is for LEAPs than for shorter term options. Options as a Strategic Investment explains this well.)
So, then we are left with the question of what strike price to buy. Strike price is a tricky subject, essentially because you have something to lose and gain regardless of whether you pick a higher or lower strike price.
The more out of the money the strike price, the less capital you tie up per option. This translates into cheaper deltas, i.e., you can buy more deltas with the same amount of dollars ([delta/$] is essentially a measure of leverage; the delta value of an option is the proportional change in the option price for a $1 change in the stock price). The temptation, of course, is to load up on far out of the money options, in the hope of getting a >100% windfall. This, of course, is not the typical behavior of a value investor, but rather a speculator. The problem with far out of the money options, then, comes from the increased probability that they will never reach the strike price and expire worthless.
The deeper in the money the option, the more capital you tie up per option. This translates into less leverage and depending on how expensive the underlying equity is, may make buying even a single LEAP an unreasonably large percentage of your portfolio. Of couse, on the other hand, deep in the money leaps behave more like the stock, and are much less likely to expire worthless.
So that leaves us with LEAPs which are near the money, either in or out. Specifically, in the next part of the series I will address the different ways that you can look at options within two strikes of the current price, and determine which ones are the best investment.
To recap the option screen:
1. Underlying stock at least 25% undervalued.
2. LEAPs available.
3. Options strike price 2 above and below the current price.
If you liked this article, please rate it.
Please visit my blog, The Doctor Investor
