364 Part Ill: Put Option Strategies
the spread with puts that are too deeply in-the-money, for this reason. While being
put will not necessarily change the profitability of the spread, it will mean increased
commission costs and margin charges for the customer, who must buy the stock upon
assignment.
A LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION)
The previous section demonstrated that ratio put calendar spreads can be attractive.
The ratio call calendar spread was described earlier as areasonably attractive strate
gy for the bullish investor. Alogical combination of these two types of ratio calendar
spreads (put and call) would be the ratio combination - buying alonger-term out-of
the-money combination and selling several near-term out-of-the-money combina
tions.
Example: The following prices exist:
XYZ common: 55
XYZ January 50 put:
XYZ January 60 call:
XYZ April 50 put: 2
XYZ April 60 call: 5
One could sell the near-term January combination (January 50 put and January 60
call) for 5 points. It would cost 7 points to buy the longer-term April combination
(April 50 put and April 60 call). By selling more January combinations than April com
binations bought, aratio calendar combination could be established. For example,
suppose that astrategist sold two of the near-term January combinations, bringing in
10 points, and simultaneously bought one April combination for 7 points. This would
be acredit position, acredit of 3 points in this example. If the near-term, out-of-the
money combination expires worthless, aguaranteed profit of 3 points will exist, even
if the longer-term options proceed to expire totally worthless. If the near-term com
bination expires worthless, the longer-term combination is owned for free, and alarge
profit could result on asubstantial stock price movement in either direction.
Although this is asuperbly attractive strategy if the near-term options do, in
fact, expire worthless, it must also be monitored closely so that large losses do not
occur. These large losses would be possible if the stock broke out in either direction
too quickly, before the near-term options expire. In the absence of atechnical opin
ion on the underlying stock, one can generally compute astock price at which it
might be reasonable to take follow-up action. This is asimilar analysis to the one

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Chapter 24: Ratio Spreads Using Puts 365
described for ratio call calendar spreads in Chapter 12. Suppose the stock in this
example began to rally. There would be apoint at which the strategist would have to
pay 3 points of debit to close the call side of the combination. That would be his
break-even point.
Example: With XYZ at 65 at January expiration (5 points above the higher strike of
the original combination), the near-term January 60 call would be worth 5 points and
the longer-term April 60 call might be worth 7 points. If one closed the call side of
the combination, he would have to pay 10 points to buy back two January 60 calls,
and would receive 7 points from selling out his April 60. This closing transaction
would be a 3-point debit. This represents abreak-even situation up to this point in
time, except for commissions, since a 3-point credit was initially taken in. The strate
gist would continue to hold the April 50 put (the January 50 put would expire worth
less) just in case the improbable occurs and the underlying stock plunges below 50
before April expiration. Asimilar analysis could be performed for the put side of the
spread in case of an early downside breakout by the underlying stock. It might be
determined that the downside break-even point at January expiration is 46, for exam
ple. Thus, the strategist has two parameters to work with in attempting to limit loss
es in case the stock moves by agreat deal before near-term expiration: 65 on the
upside and 46 on the downside. In practice, if the stock should reach these levels
before, rather than at, January expiration, the strategist would incur asmall loss by
closing the in-the-money side of the combination. This action should still be taken,
however, as the objective of risk management of this strategy is to take small losses, if
necessary. Eventually, large profits may be generated that could more than compen
sate for any small losses that were incurred.
The foregoing follow-up action was designed to handle avolatile move by the
underlying stock prior to near-term expiration. Another, perhaps more common, time
when follow-up action is necessary is when the underlying stock is relatively
unchanged at near-term expiration. If XYZ in the example above were near 55 at
January expiration, arelatively large profit would exist at that time: The near-term
combination would expire worthless for again of 10 points on that sale, and the
longer-term combination would probably still be worth about 5 points, so that the
unrealized loss on the April combination would be only 2 points. This represents atotal (realized and unrealized) gain of 8 points. In fact, as long as the near-term com
bination can be bought back for less than the original 3-point credit of the position,
the position will show atotal unrealized gain at near-term expiration. Should the gain
be taken, or should the longer-term combination be held in hopes of avolatile move
by the underlying stock? Although the strategist will normally handle each position

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366 Part Ill: Put Option Strategies
on acase-by-case basis, the general philosophy should be to hold on to the April com
bination. Aprofit is already guaranteed at this time - the worst that can happen is a
3-point profit (the original credit). Consequently, the strategist should allow himself
the opportunity to make large profits. The strategist may want to attempt to trade out
of his long combination, since he will not risk making the position alosing one by
doing so. Technical analysis may be able to provide him with buy or sell zones on the
stock, and he would then consider selling out his long options in accordance with
these technical levels.
In summary, this strategy is very attractive and should be utilized by strategists
who have the expertise to trade in positions with naked options. As long as risk man
agement principles of taking small losses are adhered to, there will be alarge proba
bility of overall profit from this strategy.
PUT OPTION SUMMARY
This concludes the section on put option strategies. The put option is useful in avari
ety of situations. First, it represents amore attractive way to take advantage of abear
ish attitude with options. Second, the use of the put options opens up anew set of
strategies - straddles and combinations - that can present reasonably high levels of
profit potential. Many of the strategies that were described in Part II for call options
have been discussed again in this part. Some of these strategies were described more
fully in terms of philosophy, selection procedures, and follow-up action when they
were first discussed. The second description the one involving put options - was
often shortened to amore mechanical description of how puts fit into the strategy.
This format is intentional. The reader who is planning to employ acertain strategy
that can be established with either puts or calls (abear spread, for example) should
familiarize himself with both applications by asimultaneous review of the call chap
ter and its analogous put chapter.
The combination strategies generally introduced new concepts to the reader.
The combination allows the construction of positions that are attractive with either
puts or calls (out-of-the-money calendar spreads, for example) to be combined into
one position. The four combination strategies that involve selling short-term options
and simultaneously buying longer-term options are complex, but are most attractive
in that they have the desirable features of limited risk and large potential profits.

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CHAPTER 25
LEAPS
In an attempt to provide customers with abroader range of derivative products, the
options exchanges introduced LEAPS. This chapter does afair amount of reviewing
basic option facts in order to explain the concepts behind LEAPS. The reader who
has aknowledge of the preceding chapters and therefore does not need the review
will be able to quickly skim through this chapter and pick out the strategically impor
tant points. However, if one encounters concepts here that don'tseem familiar, he
should review the earlier chapter that discusses the pertinent strategy.
The term LEAPS is aname for "long-term option." A LEAPS is nothing more
than alisted call or put option that is issued with two or more years of time remain
ing. It is alonger-term option than we are used to dealing with. Other than that, there
is no material difference between LEAPS and the other calls and puts that have been
discussed in the previous chapters.
LEAPS options were first introduced by the CBOE in October 1990, and were
offered on ahandful of blue-chip stocks. Their attractiveness spurred listings on
many underlying stocks on all option exchanges as well as on several indices. (Index
options are covered in alater section of the book.)
Strategies involving long-term options are not substantially different from those
involving shorter-term options. However, the fact that the option has so much time
remaining seems to favor the buyer and be adetriment to the seller. This is one rea
son why LEAPS have been popular. As astrategist, one knows that the length of time
remaining has little to do with whether acertain strategy makes sense or not. Rather,
it is the relative value of the option that dictates strategy. If an option is overpriced,
it is aviable candidate for selling, whether it has two years of life remaining or two
months. Obviously, follow-up action may become much more of anecessity during
the life of atwo-year option; that matter is discussed later in this chapter.
361

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368 Part Ill: Put Option Strategies
THE BASICS
Certain facets of LEAPS are the same as for other listed equity options, while others
involve slight differences. The amount of standardization is considerably less, which
makes the simple process of quoting LEAPS abit more tedious. LEAPS are listed
options that can be traded in asecondary market or can be exercised before expira
tion. As with other listed equity options, they do not receive the dividend paid by the
underlying common stock.
Recall that four specifications uniquely describe any option contract:
1. the type (put or call),
2. the underlying stock name (and symbol),
3. the expiration date, and
4. the striking price.
Type. LEAPS are puts or calls. The LEAPS owner has the right to buy the stock at
the striking price (LEAPS call) or sell it there (LEAPS put). This is exactly the same
for LEAPS and for regular equity options.
Underlying Stock and Quote Symbol. The underlying stocks are the
same for LEAPS as they are for equity options. The base symbol in an option quote
is the part that designates the underlying stock. For equity options, the base symbol
is the same as the stock symbol. However, until the Option Price Reporting Authority
( OPRA) changes the way that all options are quoted, the base symbols for LEAPS are
not the same as the stock symbols. For example, LEAPS options on stock XYZ might
trade under the base symbol WXY; so it is possible that one stock might have listed
options trading with different base symbols even though all the symbols refer to the
same underlying stock. Check with your broker to determine the LEAPS symbol if
you need to know it.
Expiration Date. LEAPS expire on the Saturday following the third Friday of
the expiration month, just as equity options do. One must look in the newspaper, ask
his broker, or check the Internet (www.cboe.com) to determine what the expiration
months are, however, since they are also not completely standardized. When LEAPS
were first listed, there were differing expiration months through December 1993. At
the current time, LEAPS are issued to expire in January of each year, so some
attempt is being made at standardization. However, there is no guarantee that vary
ing expiration months won'treappear at some future time.

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Chapter 25: LEAPS 369
Striking Price. There is no standardized striking price interval for LEAPS as
there is for equity options. If XYZ is a 95-dollar stock, there might be LEAPS with
striking prices of 80, 95, and 105. Again, one must look in the newspaper, ask his bro
ker, or check the Internet (www.cboe.com) to determine the actual LEAPS striking
prices for any specific underlying stock. New striking prices can be introduced when
the underlying stock rises or falls too far. For example, if the lowest strike for XYZ
were 80 and the stock fell to 80, anew LEAPS strike of 70 might be introduced.
Other Basic Factors. LEAPS may be exercised at any time during their life,
just as is the case with equity options. Note that this statement regarding exercise is
not necessarily true for Index LEAPS or Index Options. See Part Vof this book for
discussions of index products.
Standard LEAPS contracts are for 100 shares of the underlying stock, just as
equity options are. The number of shares would be adjusted for stock splits and stock
dividends (leading to even more arcane LEAPS symbol problems). LEAPS are quot
ed on aper-share basis, as are other listed options.
There are position and exercise limits for LEAPS just as there are for other list
ed options. One must add his LEAPS position and his regular equity option position
together in order to determine his entire position quantity. Exemptions may be
obtained for bona fide hedgers of common stock.
As time passes, LEAPS eventually have less than 9 months remaining until expi
ration. When such atime is reached, the LEAPS are "renamed" and become ordi
nary equity options on the underlying security.
Example: Assume LEAPS on stock XYZ were initially issued to expire two years
hence. Assume that one of these LEAPS is the XYZ January 90; that is, it has astrik
ing price of 90 and expires in January, two years from now. Its symbol is WXYAR
(WXY being the LEAPS base symbol assigned by the exchange where XYZ is traded,
Afor January, and Rfor 90).
Fifteen months later, the January LEAPS only have 9 months of life remaining.
The LEAPS symbol would be changed from WXYAR to XYZAR (aregular equity
option), and the quotes would be listed in the regular equity option section of the
newspaper instead of in the LEAPS section.
PRICING LEAPS
Terms such as in-the-money, out-of-the-money, intrinsic value, time value premium,
and parity all apply and have the same definitions. The factors influencing the prices
of LEAPS are the same as those for any other option:

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370 Part Ill: Put Option Strategies
1. underlying stock price,
2. striking price,
3. time remaining,
4. volatility,
5. risk-free interest rate, and
6. dividend rate.
The relative influence of these factors may be alittle more pronounced for
LEAPS than it is for shorter-term equity options. Consequently, the trader may think
that a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One
should be careful in his evaluation of LEAPS until he has acquired experience in
observing how their prices relate to the shorter-tenn equity options with which he is
experienced.
It might prove useful to reexamine the option pricing curve with some LEAPS
included. Please refer to Figure 25-1 for the pricing curves of several options. As
always, the solid intrinsic value line is the bottom line; it is the same for any call
option. The curves are all drawn with the same values for the pertinent variables:
stock price, striking price, volatility, short-term interest rate, and dividends. Thus,
they can be compared directly.
The most obvious thing to notice about the curves in Figure 25-1 is that the
curve depicting the 2-year LEAPS is quite flat. It has the general shape of the
shorter-term curves, but there is so much time value at stock prices even 25% in
or out-of-the-money, that the 2-year curve is much flatter than the others.
Other observations can be made as well. Notice the at-the-money options: The
2-year LEAPS sells for alittle more than four times the 3-month option. As we shall
see, this can change with the effects of interest rates and dividends, but it confirms
something that was demonstrated earlier: Time decay is not linear. Thus, the 2-year
LEAPS, which has eight times the amount of time remaining as compared to the 3-
month call, only sells for about four times as much. This LEAPS might appear cheap
to the casual observer, but remember that these graphs depict the fair values for this
set of input parameters. Do not be deluded into thinking that a LEAPS looks cheap
merely by comparing its price to anearer-term option; use amodel to evaluate it, or
at least use the output of someone else'smodel.
The curves in Figure 25-1 depict the relationships between stock price, striking
price, and time remaining. The most important remaining determinant of an option'sprice is the volatility of the underlying stock. Changes in volatility can greatly change
the price of any option. This is especially true for LEAPS, since along-term option'sprice will fluctuate greatly when volatility changes only alittle. Some observations on
the differing effects that volatility changes have on short- and long-term options are
presented later.

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Chapter 25: LEAPS
FIGURE 25-1.
LEAPS call pricing curve.
45
40
35
Q) 30 .go. 25
'lii U 20
15
10
5
, .... ,,
Various Expiration Dates
Strike= 80
2 Years (LEAP) , '
' ,,,,'
,, ,,
,, ,, ,,
"' ,, ,, ,, ,,
,,' ,,
,. ,, ,,
0 L----~==--..l.---..J£----1.---L----.I....--
60 70 80 90 100 110
Stock Price
371
Before that discussion, however, it may be beneficial to examine the effects that
interest rates and dividends can have on LEAPS. These effects are much, much
greater than those on conventional equity options. Recall that it was stated that inter
est rates and dividends are minor determinants in the price of an option, unless the
dividends were large. That statement pertains mostly to short-term options. For
longer-term options such as LEAPS, the cumulative effect of an interest rate or div
idend over such along period of time can have amagnified effect in terms of the
absolute price of the option.
Figure 25-2 presents the option pricing curve again, but the only option depict
ed is a 2-year LEAPS. The striking price is 100, and the straight line at the right
depicts the intrinsic value of the LEAPS. The three curves represent option prices
for risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration,
volatility, and dividends) are fixed. The difference between option prices caused
merely by ashift in rates of 3% is very large.
The difference in LEAPS prices increases as the LEAPS becomes in-the
money. Note that in this figure, the distance between the curves gets wider as one
scans them from left to right. The price difference for out-of-the-money LEAPS is
large enough- nearly apoint even for options fairly far out-of-the-money (that is, the
points on the left-hand side of the graph). Ashift of 3% in rates causes alarger price
difference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen
tial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but
when LEAPS strategies are examined later, the reasons for this will become clear.

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Chapter 25: LEAPS
FIGURE 25-3.
LEAPS call pricing curve as dividends increase.
30
25
(I)
.g 20
0..
C:
:g_ 15
0
10
5
0
70 80 90 100
Stock Price
With
Current
Dividend
110
373
Dividend
)> Increases
$1
T Increases
$2
120
The actual amount that the LEAPS calls lose in price increases slightly as the
call is more in-the-money. That is, the curves are closer together on the left-hand
(out-of-the-money) side than they are on the right-hand (in-the-money) side. For the
in-the-money call, a $1 increase in dividends over two years can cause the LEAPS to
be worth about 1 ½ points less in value.
Figure 25-3 is to the same scale as Figure 25-2, so they can be compared direct
ly in terms of magnitude. Notice that the effect of a $1 increase in dividends on the
LEAPS call prices is much smaller than that of an increase in interest rates by 3%.
Graphically speaking, one can observe this by noting that the spaces between the
three curves in the previous figure are much wider than the spaces between the three
curves in this figure.
Finally, note that dividend increases have the opposite effect on puts. That is,
an increase in the dividend payout of the underlying common will cause aput to
increase in price. If the put is along-term LEAPS put, then the effect of the increase
will be even larger.
Lest one think that LEAPS are too difficult to price objectively, note the follow
ing. The prior figures of interest rate and dividend effects tend to magnify the effects
on LEAPS prices for two reasons. First, they depict the effects on 2-year LEAPS. That
is alarge amount of life for LEAPS. Many LEAPS have less life remaining, so the
effects would be diminished somewhat for LEAPS with 10 to 23 months of life left.

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374 Part Ill: Put Option Strategies
Second, the figures depict the change in rates or dividends as being instantaneous.
This is not completely realistic. If rates change, they will change by alittle bit at atime,
usually¼% or½% at atime, perhaps as much as 1 %. If dividends are increased, that
increase may be instantaneous, but it will not likely occur immediately after the
LEAPS are purchased or sold. However, the point that these figures are meant to con
vey is that interest rates and dividends have amuch greater effect on LEAPS than on
ordinary shorter-term equity options, and that is certainly atrue statement.
COMPARING LEAPS AND SHORT-TERM OPTIONS
Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or
with amodel. All of the variables - stock price, volatility, interest rates, and dividends
- are given in increments and the comparison is shown between 3-month equity
options and 2-year LEAPS. There are three sets of comparisons: for options 20% out
of-the-money, options at-the-money, and options 20% in-the-money.
Afew words are needed here to explain how volatility is shown in this table.
Volatility is normally expressed as apercent. The volatility of the stock market is
about 15%. The table shows what would happen if volatility changed by one per
centage point, to 16%, for example. Of course, the table also shows what would hap
pen if the other factors changed by asmall amount.
Most of the discrepancies between the 3-month and the 2-year options are
large. For example, if volatility increases by one percentage point, the 3-month out
of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column)
while the 2-year LEAPS call will increase by 43 cents. As another example, look at
the bottom right-hand pair of numbers, which show the effect of adividend increase
on the options that are 20% in-the-money. The assumption is that the dividend will
increase 25 cents this quarter (and will be 25 cents higher every quarter thereafter).
This translates into aloss of 14 cents for the 3-month call, since there is only one ex
dividend period that affects this call; but it translates into aloss of 1 ½ for the 2-year
LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call.
TABLE 25-1.
Comparing LEAPS and Short-Term Calls.
Change in Price of the Options
20% out at 20% in
Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr .
Stock Pre. + 1 pt . 03 .41 .54 .70 .97 .89
Volatility + 1% .03 .43 .21 .48 .04 .33
Int. Rate + 1/2% .01 .27 .08 .55 .14 .72
Dividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50

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Chapter 25: LEAPS 375
The table also shows that only three of the discrepancies are not large. Two
involve the stock price change. If the stock changes in price by 1 point, neither the at
the-money nor the in-the-money options behave very differently, although the at-the
money LEAPS do jump by 70 cents. The observant reader will notice that the top line
of the table depicts the delta of the options in question; it shows the change in option
price for aone-point change in stock price. The only other comparison that is not
extremely divergent is that of volatility change for the at-the-money option. The 3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still afactor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignore the effect of arise in interest rates of ½
of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by
amere 1 %, or maybe even of the stock moving by one point (only if his option is out
of-the-money). The LEAPS option trader will gain or suffer substantially and imme
diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½
point of value - asignificant amount, to be sure.
LEAPS STRATEGIES
Many of the strategies involving LEAPS are not significantly different from their
counterparts that involve short-term options. However, as shown earlier, the long
term nature of the LEAPS can sometimes cause the strategist to experience aresult
different from that to which he has become accustomed.
As ageneral rule, one would want to be abuyer of LEAPS when interest rates
were low and when the volatilities being implied in the marketplace are low. If the
opposite were true (high rates and high volatilities), he would lean toward strategies
in which the sale of LEAPS is used. Of course, there are many other specific consid
erations when it comes to operating astrategy, but since the long-term nature of
LEAPS exposes one to interest rate and volatility movements for such along time,
one may as well attempt to position himself favorably with respect to those two ele
ments when he enters aposition.
LEAPS AS STOCK SUBSTITUTE
Any in-the-money option can be used as asubstitute for the underlying stock. Stock
owners may be able to substitute along in-the-money call for their long stock. Short
sellers of stock may be able to substitute along put for their short stock. This is not
anew idea; it was discussed briefly in Chapter 3 under reasons why people buy calls.
It has been available as astrategy for some time with short-term options. Its attrac
tiveness seems to have increased somewhat with the introduction of LEAPS, howev-

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374 Part Ill: Put Option Strategies
Second, the figures depict the change in rates or dividends as being instantaneous.
This is not completely realistic. If rates change, they will change by alittle bit at atime,
usually¼% or ½% at atime, perhaps as much as 1 %. If dividends are increased, that
increase may be instantaneous, but it will not likely occur immediately after the
LEAPS are purchased or sold. However, the point that these figures are meant to con
vey is that interest rates and dividends have amuch greater effect on LEAPS than on
ordinary shorter-term equity options, and that is certainly atrue statement.
COMPARING LEAPS AND SHORT-TERM OPTIONS
Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or
with amodel. All of the variables - stock price, volatility, interest rates, and dividends
- are given in increments and the comparison is shown between 3-month equity
options and 2-year LEAPS. There are three sets of comparisons: for options 20% out
of-the-money, options at-the-money, and options 20% in-the-money.
Afew words are needed here to explain how volatility is shown in this table.
Volatility is normally expressed as apercent. The volatility of the stock market is
about 15%. The table shows what would happen if volatility changed by one per
centage point, to 16%, for example. Of course, the table also shows what would hap
pen if the other factors changed by asmall amount.
Most of the discrepancies between the 3-month and the 2-year options are
large. For example, if volatility increases by one percentage point, the 3-month out
of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column)
while the 2-year LEAPS call will increase by 43 cents. As another example, look at
the bottom right-hand pair of numbers, which show the effect of adividend increase
on the options that are 20% in-the-money. The assumption is that the dividend will
increase 25 cents this quarter ( and will be 25 cents higher every quarter thereafter).
This translates into aloss of 14 cents for the 3-month call, since there is only one ex
dividend period that affects this call; but it translates into aloss of 1 ½ for the 2-year
LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call.
TABLE 25-1.
Comparing LEAPS and Short-Term Calls.
Change in Price of the Options
20% out al 20% in
Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr.
Stock Pre. + 1 pt .03 .41 .54 .70 .97 .89
Volatility + 1% .03 .43 .21 .48 .04 .33
Int. Rate + 1/2% .01 .27 .08 .55 .14 .72
Dividend + $.25/qtr 0 -.62 -.08 - l.18 -.14 -1.50

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Chapter 25: LEAPS 375
The table also shows that only three of the discrepancies are not large. Two
involve the stock price change. If the stock changes in price by 1 point, neither the at
the-money nor the in-the-money options behave very differently, although the at-the
money LEAPS do jump by 70 cents. The observant reader will notice that the top line
of the table depicts the delta of the options in question; it shows the change in option
price for aone-point change in stock price. The only other comparison that is not
extremely divergent is that of volatility change for the at-the-money option. The 3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still afactor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignore the effect of arise in interest rates of½
of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by
amere 1 %; or maybe even of the stock moving by one point (only if his option is out
of-the-money). The LEAPS option trader will gain or suffer substantially and imme
diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½
point of value - asignificant amount, to be sure.
LEAPS STRATEGIES
Many of the strategies involving LEAPS are not significantly different from their
counterparts that involve short-term options. However, as shown earlier, the long
term nature of the LEAPS can sometimes cause the strategist to experience aresult
different from that to which he has become accustomed.
As ageneral rule, one would want to be abuyer of LEAPS when interest rates
were low and when the volatilities being implied in the marketplace are low. If the
opposite were true (high rates and high volatilities), he would lean toward strategies
in which the sale of LEAPS is used. Of course, there are many other specific consid
erations when it comes to operating astrategy, but since the long-term nature of
LEAPS exposes one to interest rate and volatility movements for such along time,
one may as well attempt to position himself favorably with respect to those two ele
ments when he enters aposition.
LEAPS AS STOCK SUBSTITUTE
Any in-the-money option can be used as asubstitute for the underlying stock. Stock
owners may be able to substitute along in-the-money call for their long stock. Short
sellers of stock may be able to substitute along put for their short stock. This is not
anew idea; it was discussed briefly in Chapter 3 under reasons why people buy calls.
It has been available as astrategy for some time with short-term options. Its attrac
tiveness seems to have increased somewhat with the introduction of LEAPS, howev-

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376 Part Ill: Put Option Strategies
er. More and more people are examining the potential of selling the stock they own
and buying long-term calls (LEAPS) as asubstitute, or buying LEAPS instead of
making an initial purchase in aparticular common stock.
Substitution for Stock Currently Held Long. Simplistically, this strate
gy involves this line of thinking: If one owns stock and sells it, an investor could rein
vest asmall portion of the proceeds in acall option, thereby providing continued
upside profit potential if the stock rises in price, and invest the rest in abank to earn
interest. The interest earned would act as asubstitute for the dividend, if any, to
which the investor is no longer entitled. Moreover, he has less downside risk: If the
stock should fall dramatically, his loss is limited to the initial cost of the call.
In actual practice, one should carefully calculate what he is getting and what he
is giving up. For example, is the loss of the dividend too great to be compensated for
by the investment of the excess proceeds? How much of the potential gain will be
wasted in the form of time value premium paid for the call? The costs to the stock
owner who decides to switch into call options as asubstitute are commissions, the
time value premium of the call, and the loss of dividends. The benefits are the inter
est that can be earned from freeing up asubstantial portion of his funds, plus the fact
that there is less downside risk in owning the call than in owning the stock.
Example: XYZ is selling at 50. There are one-year LEAPS with astriking price of 40
that sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates
are 5%. What are the economics that an owner of 100 XYZ common stock must cal
culate in order to determine whether it is viable to sell his stock and buy the one-year
LEAPS as asubstitute?
The call has time value premium of 2 points (40 + 12 - 50). Moreover, if the
stock is sold and the LEAPS purchased, acredit of $3,800 less commissions would
be generated. First, calculate the net credit generated:
Credit balance generated:
Sale of 1 00 XYZ stock
Less stock commission
Net sale proceeds:
Cost of one LEAPS call
Plus option commission
Net cost of call:
Total credit balance:
$5,000
25
$4,975 credit
$3,760 credit
$1,200
15
$1,215 debit
Now the costs and benefits of making the switch can be computed:

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Chapter 25: LEAPS
Costs of switching:
Time value premium
Loss of dividend
Stock commissions
Option commissions
Total cost:
Fixed benefit from switching:
Interest earned on
credit balance of $3,760
at 5% interest for one year= 0.05 x $3,760:
Net cost of switching:
317
-$200
-$ 50
-$ 25
- .l__Ll_
-$290
+ $188
- $102
The stock owner must now decide if it is worth just over $1 per share in order
to have his downside risk limited to aprice of 39½ over the next year. The price of
39½ as his downside risk is merely the amount of the net credit he received from
doing the switch ($3,760) plus the interest earned ($188), expressed in per-share
terms. That is, if XYZ falls dramatically over the next year and the LEAPS expires
worthless, this investor will still have $3,948 in abank account. That is equivalent to
limiting his risk to about 39½ on the original 100 shares.
If the investor decides to make the substitution, he should invest the proceeds
from the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the
current rate - the one used in his calculations - for the year. Second, he is not tempt
ed to use the money for something else, an action that might negate the potential
benefits of the substitution.
The above calculations all assume that the LEAPS call or the stock would have
been held for the full year. If that is known not to be the case, the appropriate costs
or benefits must be recalculated.
Caveats. This ($102) seems like areasonably small price to pay to make the switch
from common stock to call ownership. However, if the investor were planning to sell
the stock before it fell to 39½ in any case, he might not feel the need to pay for this
protection. (Be aware, however, that he could accomplish essentially the same thing,
since he can sell his LEAPS call whenever he wants to.) Moreover, when the year is
up, he will have to pay another stock commission to repurchase his XYZ common if
he still wants to own it ( or he will have to pay two option commissions to roll his long
call out to alater expiration date). One other detriment that might exist, although arelatively unlikely one, is that the underlying common might declare an increased
dividend or, even worse, aspecial cash dividend. The LEAPS call owner would not
be entitled to that dividend increase in whatever form, while, obviously, the common

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378 Part Ill: Put Option Strategies
stock owner would have been. If the company declared astock dividend, it would
have no effect on this strategy since the call owner is entitled to those. Achange in
interest rates is not afactor either, since the owner of the LEAPS should invest in a
1-year Treasury bill or a 1-year CD and therefore would not be subject to interim
changes in short-term interest rates.
There may be other mitigating circumstances. Mostly these would involve tax
considerations. If the stock is currently aprofitable investment, the sale would gen
erate acapital gain, and taxes might be owed. If the stock is currently being held at
aloss, the purchase of the call would constitute awash sale and the loss could not be
taken at this time. (See Chapter 41 on taxes for abroader discussion of the wash sale
rule and option trading.)
In tl1eory, the calculations above could produce an overall credit, in which case the
stockholder W(?uld normally want to substitute with the call, unless he has overriding tax
considerations or suspects that acash dividend increase is going to be announced. Be
very careful about switching if this situation should arise. Normally, arbitrageurs - per
sons trading for exchange members and paying no commission - would take advantage
of such asituation before the general public could. If they are letting the opportunity
pass by, there must be areason (probably the cash dividend), so be extremely certain of
your economics and research before venturing into such asituation.
In summary, holders of common stock on which there exist in-the-money
LEAPS should evaluate the economics of substituting the LEAPS call for the com
mon stock. Even if arithmetic calculations call for the substitution, the stockholder
should consider his tax situation as well as his outlook for the cash dividends to be
paid by the common before making the switch.
BUYING LEAPS AS THE INITIAL PURCHASE
INSTEAD OF BUYING A COMMON STOCK
Logic similar to that used earlier to determine whether astockholder might want to
substitute a LEAPS call for his stock can be used by aprospective purchaser of com
mon stock. In other words, this investor does not already own the common. He is
going to buy it. This prospective purchaser might want to buy a LEAPS call and put
the rest of the money he had planned to use in the bank, instead of actually buying
the stock itself.
His costs - real and opportunity - are calculated in asimilar manner to those
expressed earlier. The only real difference is that he has to spend the stock commis
sion in this case, whereas he did not in the previous example (since he already owned
the stock).

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380 Part Ill: Put Option Strategies
Using Margin. The same prospective initial purchaser of common stock might
have been contemplating the purchase of the stock on margin. If he used the LEAPS
instead, he could save the margin interest. Of course, he wouldn'thave as much
money to put in the bank, but he should also compare his costs against those of buy
ing the LEAPS call instead.
Example: As before, XYZ is selling at 50; there are 1-year LEAPS with astriking
price of 40 that sell for $12; XYZ pays an annual dividend of $0.50; and short-term
interest rates are 5%. Furthermore, assume the margin rate is 8% on borrowed debit
balances.
First, calculate the difference in prospective investments:
Cost of buying the stock:
$5,000 + $25 commission:
Amount borrowed (50%)
Equity required
Cost of buying LEAPS:
$1,200 + $15 commission:
Difference (available to be placed in bank account)
$5,025
-2,512
$2,513
$1,215
$1,298
Now the costs and opportunities can be compared, if it is assumed that he buys
the LEAPS:
Costs:
Time value premium
Dividend loss
Savings:
Interest on $1,298 at 5%
Margin interest on $2,512 debit balance at 8% for one year
Net Savings:
-$200
- 50
+$ 65
+ 201
+$ 16
For the prospective margin buyer, there is areal savings in this example. The
fact that he does not have to pay the margin interest on his debit balance makes the
purchase of the LEAPS call acost-saving alternative. Finally, it should be noted that
current margin rules allow one to purchase a LEAPS option on margin. That can be
accounted for in the above calculations as well; merely reduce the investment
required and increase the margin charges on the debit balance.

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Chapter 25: LEAPS 381
In summary, aprospective purchaser of common stock may often find that if
there is an in-the-money option available, the purchase of that option is more attrac
tive than buying the common stock itself. If he were planning to buy on margin, it is
even more likely that the LEAPS purchase will be attractive. The main drawback is
that he will not participate if cash dividends are increased or aspecial dividend is
declared. Read on, however, because the next strategy may be better than the one
above.
PROTECTING EXISTING STOCK HOLDINGS WITH LEAPS PUTS
What was accomplished in the substitution strategy previously discussed? The stock
owner paid some cost ($102 in the actual example) in order to limit the risk of his
stock ownership to aprice of 39½. What if he had bought a LEAPS put instead?
Forgetting the price of the put for amoment, concentrate on what the strategy would
accomplish. He would be protected from alarge loss on the downside since he owns
the put, and he could participate in upside appreciation since he still owns the stock.
Isn'tthis what the substitution strategy was trying to accomplish? Yes, it is. In this
strategy, only one commission is paid- that being on afairly cheap out-of-the-money
LEAPS put - and there is no risk of losing out on dividend increases or special divi
dends.
The comparison between substituting acall or buying aput is arelatively sim
ple one. First, do the calculations as they were performed in the initial example
above. That example showed that the stockholder'scost would be $102 to substitute
the LEAPS call for the stock, and such asubstitution would protect him at aprice of
39½. In effect, he is paying $152 for a LEAPS put with astrike of 40- the $102 cost
plus the difference between 40 and the 39½ protection price. Now, if an XYZ 1-year
LEAPS put with strike 40 were available at 1 ½, he could accomplish everything he
had initially wanted merely by buying the put.
Moreover, he would save commissions and still be in aposition to participate
in increased cash dividends. These additional benefits should make the put worth
even more to the stockholder, so that he might pay even slightly more than 1 ½ for
the put. If the LEAPS put were available at this price, it would clearly be the bet
ter choice and should be bought instead of substituting the LEAPS call for the com
mon stock.
Thus, any stockholder who is thinking of protecting his position can do it in one
of two ways: Sell the stock and substitute acall, or continue to hold his stock and buy
aput to protect it. LEAPS calls and puts are amenable to this strategy. Because of
the LEAPS' long-term nature, one does not have to keep reestablishing his position
and pay numerous commissions, as he would with short-term options. The stock
holder should perform the simple calculations as shown above in order to decide

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382 Part Ill: Put Option Strategies
whether the move is feasible at all, and if it is, whether to use the call substitution
strategy or the put protection strategy.
LEAPS INSTEAD OF SHORT STOCK
Just as in-the-money LEAPS calls may sometimes be asmarter purchase than the
stock itself, in-the-money puts may sometimes be abetter purchase than shorting the
common stock. Recall that either the put purchase or the short sale of stock is abear
ish strategy, generally implemented by someone who expects the stock to decline in
price. The strategist knows, however, that short stock is acomponent of many strate
gies and might reflect other opinions than pure bearishness on the common. In any
case, an in-the-money put may prove to be aviable substitute for shorting the stock
itself. The two main advantages that the put owner has are that he has limited risk
(whereas the short seller of stock has theoretically unlimited risk); and he does not
have to pay out any dividends on the underlying stock as the short seller would. Also,
the commissions for buying the put would normally be smaller than those required
to sell the stock short.
There is not much in the way of calculating that needs to be done in order to
make the comparison between buying the in-the-money put and shorting the stock.
If the time value premium spent is small in comparison \vith the dividend payout that
is saved, then the put is probably the better choice.
Professional arbitrageurs and other exchange members, as well as some large
customers, receive interest on their short sales. For these traders, the put would have
to be trading with virtually no time premium at all in order for the comparison to
favor the put purchase over the stock short sale. However, the public customer who
is going to be shorting stock should be aware of the potential for buying an in-the
money put instead.
SPECULATIVE OPTION BUYING WITH LEAPS
Strategists know that buying calls and puts can have various applications; witness the
stock substitution strntegies above. However, the most popular reason for buying
options is for speculative gain. The leverage inherent in owning options and their lim
ited risk feature make them attractive for this purpose as well. The risk, of course,
can be 100% of the investment, and time decay works against the option owner as
well. LEAPS calls and puts fit all of these descriptions; they simply have longer matu
rities.
Time decay is the major enemy of the speculative option holder. Purchasing
LEAPS options instead of the shorter-term equity options generally exposes the

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Chapter 25: LEAPS 383
buyer to less risk of time decay on adaily basis. This is true because the extreme neg
ative effects of time decay magnify as the option approaches its expiration. Recall that
it was shown in Chapter 3 that time decay is not linear: An option decays more rap
idly at the end of its life than at the beginning. Eventually, a LEAPS put or call will
become anormal short-term equity option and time will begin to take amore rapid
toll. But in the beginning of the life of LEAPS, there is so much time remaining that
the short-term decay is not large in terms of price.
Table 25-2 and Figure 25-4 depict the rate of decay of two options: one is at
the-money (the lower curve) and the other is 20% out-of-the-money (the upper
curve). The horizontal axis is months of life remaining until expiration. The vertical
axis is the percent of the option price that is lost daily due to time decay. The options
that qualify as LEAPS are ones with more than 9 months oflife remaining, and would
thus be the ones on the lower right-hand part of the graph.
The upward-sloping nature of both curves as time to expiration wanes shows
that time decay increases more rapidly as expiration approaches. Notice how much
more rapidly the out-of-the-money option decays, percentagewise, than the at-the
money. LEAPS, however, do not decay much at all compared to normal equity
options. Most LEAPS, even the out-of-the-money ones, lose less than¼ of one per
cent of their value daily. This is apittance when compared with a 6-month equity
option that is 20% out-of-the-money- that option loses well over 1 % of its value daily
and it still has 6 months of life remaining.
From the accompanying table, observe that the out-of-the-money 2-month
option loses over 4% of its value daily!
Thus, LEAPS do not decay at arapid rate. This gives the LEAPS holder achance to have his opinion about the stock price work for him without having to
worry as much about the passage of time as the average equity option holder would.
An advantage of owning LEAPS, therefore, is that one'stiming of the option pur
chase does not have to be as exact as that for shorter-term option buying. This can be
agreat psychological advantage as well as astrategic advantage. The LEAPS option
buyer who feels strongly that the stock will move in the desired direction has the lux
ury of being able to wait calmly for the anticipated move to take place. If it does not,
even in perhaps as long as 6 months' time, he may still be able to recoup areason
able portion of his initial purchase price because of the slow percentage rate of decay.
Do not be deluded into believing that LEAPS don'tdecay at all. Although the
rate of decay is slow (as shown previously), an option that is losing 0.15% of its value
daily will still lose about 25% of its value in six months.
Example: XYZ is at 60 and there are 18-month LEAPS calls selling for $8, with astriking price of 60. The daily decay of this call with respect to time will be minus-

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Chapter 25: LEAPS 385
Those familiar with holding equity calls and puts are more accustomed to seeing
an option lose 25% of its value in possibly as little as four or five weeks' time. Thus, the
advantage of holding the LEAPS is obvious from the viewpoint of slower time decay.
This observation leads to the obvious question: "When is the best time to sell my
call and repurchase alonger-term one?" Referring again to the figure above may help
answer the question. Note that for the at-the-money option, the curve begins to bend
dramatically upward soon after the 6-month time barrier is passed. Thus, it seems log
ical that to minimize the effects of time decay, all other things being equal, one would
sell his long at-the-money call when it has about 6 months of life left and simultane
ously buy a 2-year LEAPS call. This keeps his time decay exposure to a. minimum.
The out-of-the-money call is more radical. Figure 25-4 shows that the call that
is 20% out-of-the-money begins to decay much more rapidly (percentagewise) at
sometime just before it reaches one year until expiration. The same logic would dic
tate, then, that if one is trading out-of-the-money options, he would sell his option
held long when it has about one year to go and reestablish his position by buying a 2-
year LEAPS option at the same time.
ADVANTAGES OF BUYING HCHEAP"
It has been demonstrated that rising interest rates or rising volatility would make the
price of a LEAPS call increase. Therefore, if one is attempting to participate in
LEAPS speculative call buying strategies, he should be more aggressive when rates
and volatilities are low.
Afew sample prices may help to demonstrate just how powerful the effects of
rates and volatilities are, and how they can be afriend to the LEAPS call buyer. Suppose
that one buys a 2-year LEAPS call at-the-money when the following situation exists:
XYZ: 100
January 2-year LEAPS call with strike of 100: 14
Short-term interest rates: 3%
Volatility: below average (historically)
For the purposes of demonstration, suppose that the current volatility is low for XYZ
(historically) and that 3% is alow level for rates as well. If the stock moves up, there
is no problem, because the LEAPS call will increase in price. But what if the stock
drops or stays unchanged? Is all hope of aprofit lost? Actually, no. If interest rates
increase or the volatility that the calls trade at increases, we know the LEAPS call will
increase in value as well. Thus, even though the direction in which the stock is mov
ing may be unfavorable, it might still be possible to salvage one'sinvestment. Table
25-3 shows where volatility would have to be or where short-term rates would have

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386 Part Ill: Put Option Strategies
TABLE 25-3.
Factors necessary for January 2-year LEAPS to be = 14.
Stock price After lmonth
100 (unchanged) r = 3 .4% or
V + 5%
95
90
r = 6% or
V + 20%
r = 8.5% or
V + 45%
After 6 months
r = 6% or
V + 20%
r = 9.4% or
V + 45%
r = 12.6% or
V + 70%
to go in order to keep the value of the LEAPS call at 14 even after the indicated
amount of time had expired.
To demonstrate the use of this table, suppose the stock price were 100
(unchanged) after one month. If interest rates had 1isen to 3.4% from their original
level of 3% during that time, the call would still be worth 14 even though one month
had passed. Alternatively, if rates were the same, but volatility had increased by only
5% from its original level, then the call would also still be worth 14. Note that this
means that volatility would have to increase only slightly (by ½oth) from its original
level, not by 5 percentage points.
Even if the stock were to drop to 90 and six months had passed, the LEAPS call
holder would still be even if rates had iisen to 12.6% (highly unlikely) or volatility had
risen by 70%. It is often possible for volatilities to fluctuate to that extent in six
months, but not likely for interest rates.
In fact, as interest rates go, only the top line of the table probably represents
realistic interest rates; an increase of 0.4% in one month, or 3% in 6 months, is pos
sible. The other lines, where the stock drops in price, probably require too large ajump in rates for rates alone to be able to salvage the call price. However, any
increase in rates will be helpful. Volatility is another matter. It is often feasible for
volatilities to change by as much as 50% from their previous level in amonth, and
certainly in six months. Hence, as has been stated before, the volatility factor is the
more dominant one.
This table shows the effect of rising interest rates and volatilities on LEAPS
calls. It would be beneficial to the LEAPS call owner and, of course, detrimental to
the LEAPS call seller. This is clear evidence that one should be aware of the gener
al level of rates and volatility before using LEAPS options in astrategy.

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Chapter 25: LEAPS
THE DELTA
387
The delta of an option is the amount by which the option price will change if the
underlying stock changes in price by one point. In an earlier section of this chapter,
comparing the differences between LEAPS and short-term calls, mention was made
of delta. The subject is explored in more depth here because it is such an important
concept, not only for option buyers, but for most strategic decisions as well.
Figure 25-5 depicts the deltas of two different options: 2-year LEAPS and 3-
month equity options. Their terms are the same except for their expiration dates; strik
ing price is 100, and volatility and interest rate assumptions are equal. The horizontal
axis displays the stock price while the vertical axis shows the delta of the options.
Several relevant observations can be made. First, notice that the delta of the at
the-money LEAPS is very large, nearly 0.70. This means that the LEAPS call will
move much more in line with the common stock than acomparable short-term equi
ty option would. Very short-term at-the-money options have deltas of about½, while
slightly longer-term ones have deltas ranging up to the 0.55 to 0.60 area. What this
implies is that the longer the life of an at-the-nwney option, the greater its delta.
In addition, the figure shows that the deltas of the 3-month call and the 2-year
LEAPS call are about equal when the options a~eapproximately 5% in-the-money. If
the options are more in-the-money than that, then the LEAPS call has alower delta.
This means that at- and out-of-the-money LEAPS will move more in line with the
common stock than comparable short-term options will. Restated, the LEAPS calls
will move faster than the ordinary short-term equity calls unless both options are
more than 5% in-the-money. Note that the movement referred to is in absolute terms
in change of price, not in percentage terms.
The delta of the 2-year LEAPS does not change as dramatically when the
stock moves as does the delta of the 3-month option (see Figure 25-5). Notice that
the LEAPS curve is relatively flat on the chart, rising only slightly above horizon
tal. In contrast, the delta of the 3-month call is very low out-of-the-money and very
large in-the-money. What this means to the call buyer is that the amount by which
he can expect the LEAPS call to increase or decrease in price is somewhat stable.
This can affect his choice of whether to buy the in-the-money call or the out-of
the-money call. With normal short-term options, he can expect the in-the-money
call to much more closely mirror the movement in the stock, so he might be tempt
ed to buy that call if he expects asmall movement in the stock. With LEAPS, how
ever, there is much less discrepancy in the amount of option price movement that
will occur.

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388 Part Ill: Put Option Strategies
FIGURE 25·5.
Call delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70
8 60 ,...
X
.l!l 50
Q)
0 40
30 t= 3 months
20
10
O 70 80 90 100 110 120 130
Stock Price
Example: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and
there are 2-year LEAPS calls at those strikes as well. The following table summarizes
the available information:
XYZ: 82 Date: January, 2002
Option Price Delta
April ('02) 80 call 4 s/a
April ('02) 90 call i/a
January ('04) 80 LEAPS call 14 3/4
January ('04) 90 LEAPS call 7 1/2
Suppose the trader expects a 3-point move by the underlying common stock, from 82
to 85. If he were analyzing short-term calls, he would see his potential as again of 17/sin the April 80 call versus again of 3/sin the April 90 call. Each of these gains is pro
jected by multiplying the call'sdelta times 3 (the expected stock move, in points).
Thus, there is alarge difference between the expected gains from these two options,
particularly after commissions are considered.
Now observe the LEAPS. The January 80 would increase by 2¼ while the
January 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near
ly as large adiscrepancy as the short-term options had. Observe that the January 90
LEAPS sells for half the price of the January 80. These movements projected by the

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Chapter 25: LEAPS 389
delta indicate that the January 90 LEAPS will move by alarger percentage than the
January 80 and therefore would be the better buy.
PUT DELTAS
Many of the previous observations regarding deltas of LEAPS calls can be applied to
LEAPS puts as well. However, Figure 25-5 changes alittle when the following for
mula is applied. Recall that the relationship between put deltas and call deltas, except
for deeply in-the-money puts, is:
Put delta = Call delta - 1
This has the effect of inverting the relationships that have just been described.
In other words, while the short-term calls didn'tmove as fast as the LEAPS, the
short-term puts move Jaster than the LEAPS puts in most cases. Figure 25-6 shows
the deltas of these options.
The vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS
puts and short-term equity puts don'tbehave very differently in terms of price
change (bottom right-hand section of figure).
In-the-money puts (when the stock is below the striking price) move faster if
they are shorter-term. This fact is accentuated even more when the puts are more
deeply in-the-money. The left-hand side of the figure depicts this fact.
FIGURE 25-6.
Put delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70 t= 3 months
0 60
0
1 50
X
Jg 40
Q)
0
30
20
10
O 70 80 90 100 110 120 130
Stock Price

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388 Part Ill: Put Option Strategies
FIGURE 25-5.
Call delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70
g 60
; 50
~
O 40
30 t= 3 months
20
10
O 70 80 90 100 110 120 130
Stock Price
Example: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and
there are 2-year LEAPS calls at those strikes as well. The following table summarizes
the available information:
XYZ: 82 Date: January, 2002
Option Price Delta
April ('02) 80 call 4 s/a
April ('02) 90 call 1 i/s
January ('04) 80 LEAPS call 14 3/4
January ('04) 90 LEAPS call 7 1/2
Suppose the trader expects a 3-point move by the underlying common stock, from 82
to 85. Ifhe were analyzing short-term calls, he would see his potential as again of F/sin the April 80 call versus again of 3/sin the April 90 call. Each of these gains is pro
jected by multiplying the call'sdelta times 3 (the expected stock move, in points).
Thus, there is alarge difference behveen the expected gains from these two options,
particularly after commissions are considered.
Now observe the LEAPS. The January 80 would increase by 2¼ while the
January 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near
ly as large adiscrepancy as the short-term options had. Observe that the January 90
LEAPS sells for half the price of the January 80. These movements projected by the

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Chapter 25: LEAPS 389
delta indicate that the January 90 LEAPS will move by alarger percentage than the
January 80 and therefore would be the better buy.
PUT DELTAS
Many of the previous observations regarding deltas of LEAPS calls can be applied to
LEAPS puts as well. However, Figure 25-5 changes alittle when the following for
mula is applied. Recall that the relationship between put deltas and call deltas, except
for deeply in-the-money puts, is:
Put delta = Call delta - 1
This has the effect of inverting the relationships that have just been described.
In other words, while the short-term calls didn'tmove as fast as the LEAPS, the
short-term puts nwve fa,ster than the LEAPS puts in nwst cases. Figure 25-6 shows
the deltas of these options.
The vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS
puts and short-term equity puts don'tbehave very differently in terms of price
change (bottom right-hand section offigure).
In-the-money puts (when the stock is below the striking price) move faster if
they are shorter-term. This fact is accentuated even more when the puts are more
deeply in-the-money. The left-hand side of the figure depicts this fact.
FIGURE 25-6.
Put delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70 t= 3 months
0 60
0
1 50
X
Jg 40
Q)
0
30
20
10
O 70 80 90 100 110 120 130
Stock Price

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390 Part Ill: Put Option Strategies
The LEAPS put delta curve is flat, just as the call delta curve was. Moreover,
the delta is not very large anywhere across the figure. For example, at-the-money 2-
year LEAPS puts move only about 30 cents for aone-point move in the underlying
stock. LEAPS put buyers who want to speculate on astock'sdownward movement
must realize that the leverage factor is not large; it takes approximately a 3-point
move by the underlying common for an at-the-money LEAPS put to increase in
value by one point. Long-term puts don'tmirror stock movement nearly as well as
shorter-term puts do.
In summary, the option buyer who is considering buying LEAPS puts or calls as
speculation should be aware of the different price action that LEAPS exhibit when
compared to shorter-term options. Due to the large amount of time that LEAPS have
remaining in their lives, the time decay of the LEAPS options is smaller. For this rea
son, the LEAPS option buyer doesn'tneed to be as precise in his timing. In general,
LEAPS calls move faster when the underlying stock moves, and LEAPS puts move
more slowly. Other than that, the general reasons for speculative option buying apply
to LEAPS as well: leverage and limited risk.
SELLING LEAPS
Strategies involving selling LEAPS options do not differ substantially from those
involving shorter-term options. The discussions in this section concentrate on the two
major differences that sellers of LEAPS will notice. First, the slow rate of time decay
of LEAPS options means that option writers who are used to sitting back and watch
ing their written options waste away will not experience the same effect with LEAPS.
Second, follow-up action for writing strategies usually depends on being able to buy
back the w1itten option when it has little or no time value premium remaining. Since
LEAPS retain time value even when substantially in- or out-of-the-money, follow-up
action involving LEAPS may involve the repurchase of substantial amounts of time
value premium.
COVERED WRITING
LEAPS options can be sold against underlying stock just as short-term options can.
No extra collateral or investment is required to do so. The resulting position is again
one with limited profit potential, but enhanced profitability (as compared to stock
ownership), if the underlying stock remains unchanged or falls. The maximum prof
it potential of the covered write is reached whenever the underlying stock is at or
above the striking price of the written option at expiration.
The LEAPS covered writer takes in substantial premium, in terms of price,
when he sells the long-term option. He should compare the return that he could

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Chapter 25: LEAPS 391
make from the LEAPS write with returns that can be made from repeatedly writing
shorter-term calls. Of course, there is no guarantee that he will actually be able to
repeat the short-term writes during the longer life of the LEAPS.
As an aside, the strategist who is utilizing the incremental return concept of cov
ered writing may find LEAPS call writing quite attractive. This is the strategy where
in he has ahigher target price at which he would be willing to sell his common stock,
and he writes calls along the way to earn an incremental return (see Chapter 2 for
details). Since this type of writer is only concerned with absolute levels of premiums
being brought into the account and not with things like return if exercised, he should
utilize LEAPS calls if available, since the premiums are the largest available.
Moreover, if the incremental return writer is currently in ashort-term call and is
going to be called away, he might roll into a LEAPS call in order to retain his stock
and take in more premium.
The rest of this section discusses covered writing from the more normal view
point of the investor who buys stock and sells acall against it in order to attain apar
ticular return.
Example: XYZ is selling at 50. The investor is considering a 500-share covered write
and he is unsure whether to use the 6-month call or the 2-year LEAPS. The July 50
call sells for 4 and has 6 months of life remaining; the January 50 LEAPS call sells for
8½ and has 2 years of life. Further assume that XYZ pays adividend of $0.25 per
quarter.
As was done in Chapter 2, the net required investment is calculated, then the
return (if exercised) is computed, and finally the downside break-even point is deter
mined.
Stock cost (500 shares @ 50)
Plus stock commission
Less option premiums received
Plus option commissions
Net cash investment
Net Investment Required
July 50 call
$25,000
+ 300
2,000
+ 50
$23,350
January 50 LEAPS
$25,000
+ 300
4,250
+ 100
$21,150
Obviously, the LEAPS covered writer has asmaller cash investment, since he is sell
ing amore expensive call in his covered write. Note that the option premium is being
applied against the net investment in either case, as is the normal custom when doing
covered writing.
Now, using the net investment required, one can calculate the return (if exer
cised). That return assumes the stock is above the striking price of the written option

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392 Part Ill: Put Option Strategies
at its expiration, and the stock is called away. The short-term writer would have col
lected two dividends of the common stock, while the LEAPS writer would have col
lected eight by expiration.
Stock sale (500 @ 50)
Less stock commission
Plus dividends earned
until expiration
Less net investment
Net profit if exercised
Return if exercised
(net profit/net investment)
Return If Exercised
+
July 50 call
$25,000
300
250
- 23,350
$ 1,600
6.9%
January 50 LEAPS
$25,000
300
+ 1,000
- 21,150
$ 4,550
21.5%
The LEAPS writer has amuch higher net return if exercised, again because he
wrote amore expensive option to begin with. However, in order to fairly compare the
two writes, one must annualize the returns. That is, the July 50 covered write made
6.9% in six months, so it could make twice that in one year, if it can be duplicated six
months from now. In asimilar manner, the LEAPS covered writer can make 21.5%
in two years if the stock is called away. However, on an annualized basis, he would
make only half that amount.
Return If Exercised, Annualized
July 50 call January 50 LEAPS
13.8% 10.8%
Thus, on an annualized basis, the short-term write seems better. The shorter-term
call will generally have ahigher rate of return, annualized, than the LEAPS call. The
problems with annualizing are discussed in the following text.
Finally, the downside break-even point can be computed for each write.
Downside Break-Even Calculation
Net investment
Less dividends received
Total stock cost to expiration
Divided by shares held (500),
equals break-even price:
July 50 call
$23,350
250
$23,100
46.2
January 50 LEAPS
$21,150
1 000
$20,150
40.3

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Chapter 25: LEAPS 393
The larger premium of the LEAPS call that was written produces this dramatically
lower break-even price for the LEAPS covered write.
Similar comparisons could be made for acovered write on margin if the investor
is using amargin account. The steps above are the mechanical ones that acovered
writer should go through in order to see how the short-term write compares to the
longer-term LEAPS write. Analyzing them is often aless routine matter. It would
seem that the short-term write is better if one uses the annualized rate of return.
However, the annualized return is asomewhat subjective number that depends on
several assumptions.
The first assumption is that one will be able to generate an equivalent return six
months from now when the July 50 call expires worthless or the stock is called away.
If the stock were relatively unchanged, the covered writer would have to sell a 6-
month call for 4 points again six months from now. Or, if the stock were called away,
he would have to invest in an equivalent situation elsewhere. Moreover, in order to
reach the 2-year horizon offered by the LEAPS write, the 6-month return would
have to be regenerated three more times (six months from now, one year from now,
and ayear and ahalf from now). The covered writer cannot assume that such returns
can be repeated with any certainty every six months.
The second assumption that was made when the annualized returns were cal
culated was that one-half the return if exercised on the LEAPS call would be made
when one year had passed. But, as has been demonstrated repeatedly in this chapter,
the time decay of an option is not linear. Therefore, one year from now, if XYZ were
still at 50, the January 50 LEAPS call would not be selling for half its current price
(½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors
remained unchanged. However, given the variability of LEAPS call premiums when
interest rates, volatility, or dividend payouts change, it is extremely difficult to esti
mate the call price one year from now. Consequently, to say that the 21.5% 2-year
return if exercised would be 10.8% after one year may well be afalse statement.
Thus, the covered writer must make his decision based on what he knows. He
knows that with the short-term July 50 write, if the stock is called away in six months,
he will make 6.9%, period. If he opts for the longer term, he will make 21.5% if he
is called away in two years. Which is better? The question can only be answered by
each covered writer individually. One'sattitude toward long-term investing will be amajor factor in making the decision. If he thinks XYZ has good prospects for the long
term, and he feels conservative returns will be below 10% for the next couple of
years, then he would probably choose the LEAPS write. However, if he feels that
there is atemporary expansion of option premium in the short-term XYZ calls that
should be exploited, and he would not really want to be along-term holder of the
stock, then he would choose the short-term covered write.

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394 Part Ill: Put Option Strategies
Downside Protection. The actual downside break-even point might enter into
one'sthinking as well. Adownside break-even point of 40.3 is available by using the
LEAPS write, and that is aknown quantity. No matter how far XYZ might fall, as long
as it can recover to slightly over 40 by expiration two years from now, the investment
will at least break even. Aproblem arises if XYZ falls to 40 quickly. If that happened,
the LEAPS call would still have asignificant amount of time value premium remain
ing on it. Thus, if the investor attempted to sell his stock at that time and buy back
his call, he would have aloss, not abreak-even situation.
The short-term write offers downside protection only to astock price of 46.2.
Of course, repeated writes of 6-month calls over the next 2 years would lower the
break-even point below that level. The problem is that if XYZ declines and one is
forced to keep selling 6-month calls every 6 months, he may be forced to use alower
striking price, thereby locking in asmaller profit ( or possibly even aloss) if premium
levels shrink. The concepts of rolling down are described in detail in Chapter 2.
Afurther word about rolling down may be in order here. Recall that rolling
down means buying back the call that is currently written and selling another one
with alower striking price. Such action always reduces the profitability of the over
all position, although it may be necessary to prevent further downside losses if the
common stock keeps declining. Now that LEAPS are available, the short-term writer
faced with rolling down may look to the LEAPS as ameans of bringing in ahealthy
premium even though he is rolling down. It is true that alarge premium could be
brought into the account. But remember that by doing so, one is committing himself
to sell the stock at alower price than he had originally intended. This is why the
rolling down reduces the original profit potential. If he rolls down into a LEAPS call,
he is reducing his maximum profit potential for alonger period of time.
Consequently, one should not always roll dm,vn into an option with alonger maturi
ty. Instead, he should carefully analyze whether he wants to be committed for an
even longer time to aposition in which the underlying common stock is declining.
To summarize, the large absolute premiums available in LEAPS calls may make
acovered write of those calls seem unusually attractive. However, one should calcu
late the returns available and decide whether ashort-term write might not serve his
purpose as well. Even though the large LEAPS premium might reduce the initial
investment to amere pittance, be aware that this creates agreat amount of leverage,
and leverage can be adangerous thing.
The large amount of downside protection offered by the LEAPS call is real, but
if the stock falls quickly, there would definitely be aloss at the calculated downside
break-even point. Finally, one cannot always roll down into a LEAPS call if trouble
develops, because he will be committing himself for an even longer period of time to
sell his stock at alower price than he had originally intended.

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Chapter 25: LEAPS 39S
✓,,FREE" COVERED CALL WRITES
In Chapter 2, astrategy of writing expensive LEAPS options was briefly described.
In this section, amore detailed analysis is offered. Acertain type of covered call
write, one in which the call is quite expensive, sometimes attracts traders looking for
a "free ride." To acertain extent, this strategy is something of afree ride. As you
might imagine, though, there can be major problems.
The investment required for acovered call write on margin is 50% of the stock
price, less the proceeds received from selling the call. In theory, it is possible for an
option to sell for more than 50% of the stock cost. This is amargin account, acov
ered write could be established for "free." Let'sdiscuss this in terms of two types of
calls: the in-the-money call write and the out-of-the-money call write.
Out-of-the-Money Covered Call Write. This is the simplest way to approach
the strategy. One may be able to find LEAPS options that are just slightly out-of-the
money, which sell for 50% of the stock price. Understandably, such astock would be
quite volatile.
Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a
2-year LEAPS call with astriking price of 40 is selling for $19. The requirement for
this covered write would be zero, although some commission costs would be
involved. The debit balance would be 19 points per share, the amount the broker
loans you on margin.
Certain brokerage firms might require some sort of minimum margin deposit, but
technically there is no further requirement for this position. Of course, the leverage
is infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls,
covered. His risk is $190,000 if the stock falls to zero! That also happens to be the
debit balance in his account. Thus, for aminimal investment, one could lose afor
tune. In addition, if the stock begins to fall, one'sbroker is going to want maintenance
margin. He probably wouldn'tlet the stock slip more than acouple of points before
asking for margin. If one owns 10,000 shares and the broker wants two points main
tenance margin, that means the margin call would be $20,000.
The profits wouldn'tbe as big as they might at first seem. The maximum gross
profit potential is $210,000 if the 10,000 shares are called away at 40. The covered
write makes 21 points on each share - the $40 sale price less the original cost of $19.
However, one will have had to pay interest on the debit balance of $190,000 for two
years. At 10%, say, that'satotal of $38,000. There would also be commissions on the
purchase and the sale.

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396 Part Ill: Put Option Strategies
In summary, this is aposition with tremendous, even dangerous, leverage.
In-the-Money Covered Call Write. The situation is slightly different if the
option is in-the-money to begin with. The above margin requirements actually don'tquite accurately state the case for amargined covered call write. When acovered call
is written against the stock, there is acatch: Only 50% of the stock price or the strike
price, whichever is less, is available for "release." Thus, one will actually be required
to put up more than 50% of the stock price to begin with.
Example: XYZ is trading at 50, and there is a 2-year LEAPS call with astrike price
of 30, selling for 25 points. One might think that the requirement for acovered call
write would be zero, since the call sells for 50% of the stock price. But that'snot the
case with in-the-money covered calls.
Margin requirement:
Buy stock: 50 points
Less option proceeds -25
Less margin release* -15*
Net requirement: 10 points
* 50% of the strike price or 50% of stock price, whichever is less.
This position still has alot ofleverage: One invests 10 points in hopes of making 5, if
the stock is called away at 30. One also would have to pay interest on the 15-point
debit balance, of course, for the two-year duration of the position. Furthermore,
should the stock fall below the strike price, the broker would begin to require main
tenance margin.
Note that the above "formula" for the net requirement works equally well for
the out-of-the-money covered call write, since 50% of the stock price is always less
than 50% of the strike price in that case.
To summarize this "free ride" strategy: If one should decide to use this strate
gy, he must be extremely aware of the dangers of high leverage. One must not risk
more money than he can afford to lose, regardless of how small the initial investment
might be. Also, he must plan for some method of being able to make the margin pay
ments along the way. Finally, the in-the-money alternative is probably better, because
there is less probability that maintenance margin will be asked for.
SELLING UNCOVERED LEAPS
Uncovered option selling can be aviable strategy, especially if premiums are over
priced. LEAPS options may be sold uncovered with the same margin requirements
as short-term options. Of course, the particular characteristics of the long-term
option may either help or hinder the uncovered writer, depending on his objective.

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Chapter 25: LEAPS 397
Uncovered Put Selling. Naked put selling is addressed first because, as astrat
egy, it is equivalent to covered writing, and covered writing was just discussed. Two
strategies are equivalent if they have the same profit picture at expiration. Naked put
selling and covered call writing are equivalent because they have the profit picture
depicted in Graph I, Appendix D. Both have limited upside profit potential and large
loss exposure to the downside. In general, when two strategies are equivalent, one of
the two has certain advantages over the other.
In this case, naked put selling is normally the more advantageous of the two
because of the way margin requirements are set. One need not actually invest cash
in the sale of anaked put; the margin requirement that is asked for may be satisfied
with collateral. This means the naked put writer may use stocks, bonds, T-bills, or
money market funds as collateral. Moreover, the actual amount of collateral that is
required is less than the cash or margin investment required to buy stock and sell acall. This means that one could operate his portfolio normally - buying stock, then
selling it and putting the proceeds in a Treasury bill or perhaps buying another stock
- without disturbing his naked put position, as long as he maintained the
collateral requirement.
Consequently, the strategist who is buying stock and selling calls should probably
be selling naked puts instead. This does not apply to covered writers who are writing
against existing stock or who are using the incremental return concept of covered writ
ing, because stock ownership is part of their strategy. However, the strategist who is
looking to take in premium to profit if the underlying stock remains relatively
unchanged or rises, while having amodicum of downside protection ( which is the
definition of both naked put writing and covered writing), should be selling naked
puts. As an example of this, consider the LEAPS covered write discussed previously.
Example: XYZ is selling at 50. The investor is debating between a 500-share covered
write using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50
LEAPS call sells for 8½ and has two years of life, while the January 50 LEAPS put
sells for 3½. Further assume that XYZ pays adividend of $0.25 per quarter.
The net investment required for the covered write is calculated as it was before.
Net Investment Required - Covered Write
Stock cost (500 shares @ 50)
Plus stock commission
Less option premiums received
Plus option commissions
Net cash investment
+
$25,000
300
- 4,250
+ 100
$21,150

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398 Part Ill: Put Option Strategies
The collateral requirement for the naked put write is the same as that for any
naked equity option: 20% of the stock price, plus the option price, less any out-of
the-money amount, with an absolute minimum requirement of 15% of the stock
price.
Collateral Requirement - Naked Put
20% of stock price (.20 x 500 x $50)
Plus option premium
Less out-of-the-money amount
Total collateral requirement
$5,000
1,750
0
$6,750
Note that the actual premium received by the naked put seller is $1,750 less com
missions of $100, for example, or $1,650. This net premium could be used to reduce
the total collateral requirement.
Now one can compare the profitability of the two investments:
Return If Stock Over 50 at Expiration
Stock sale {500 @ 50)
Less stock commission
Plus dividends earned until expiration
Less net investment
Net profit if exercised
Net put premium received
Dividends received
Net profit
Covered Write
$25,000
300
+ 1,000
- 21,150
$ 4,55_0
Naked Put Sole
$1,650
0
$1,650
Now the returns can be compared, if XYZ is over 50 at expiration of the LEAPS:
Return if XYZ over 50
(net profit/net investment)
Naked put sale: 24.4%
Covered write: 21 .5%
The naked put write has abetter rate of return, even before the following fact
is considered. The strategist who is using the naked put write does not have to spend
the $6,750 collateral requirement in the form of cash. That money can be kept in a

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Chapter 25: LEAPS 399
Treasury bill and earn interest over the two years that the put write is in place. Even
if the T-bill were earning only 4% per year, that would increase the overall two-year
return for the naked put sale by 8%, to 32.4%. This should make it obvious that naked
put selling is rrwre strategically advantageous than covered call writing.
Even so, one might rightfully wonder if LEAPS put selling is better than selling
shorter-term equity puts. As was the case with covered call writing, the answer
depends on what the investor is trying to accomplish. Short-term puts will not bring
as much premium into the account, so when they expire, one will be forced to find
another suitable put sale to replace it. On the other hand, the LEAPS put sale brings
in alarger premium and one does not have to find areplacement until the longer
term LEAPS put expires. The negative aspect to selling the LEAPS puts is that time
decay won'thelp much right away and, even if the stock moves higher (which is
ostensibly good for the position), the put won'tdecline in price by alarge amount,
since the delta of the put is relatively small.
One other factor might enter in the decision regarding whether to use short
term puts or LEAPS puts. Some put writers are actually attempting to buy stock
below the market price. That is, they would not mind being assigned on the put they
sell, meaning that they would buy stock at anet cost of the striking price less the pre
mium they received from the sale of the put. If they don'tget assigned, they get to
keep aprofit equal to the premium they received when they first sold the put.
Generally, aperson would only sell puts in this manner on astock that he had faith
in, so that if he was assigned on the put, he would view that as abuying opportunity
in the underlying stock. This strategy does not lend itself well to LEAPS. Since the
LEAPS puts will carry asignificant amount of time premium, there is little (if any)
chance that the put writer will actually be assigned until the life of the put shortens
substantially. This means that it is unlikely that the put writer will become astock
owner via assignment at any time in the near future. Consequently, if one is attempt
ing to wTite puts in order to eventually buy the common stock when he is assigned,
he would be better served to write shorter-term puts.
UNCOVERED CALL SELLING
There are very few differences between using LEAPS for naked call selling and using
shorter-term calls, except for the ones that have been discussed already with regard
to selling uncovered LEAPS: Time value decay occurs more slowly and, if the stock
rallies and the naked calls have to be covered, the call writer will normally be paying
more time premium than he is used to when he covers the call. Of course, the rea
son that one is engaged in naked call writing might shed some more light on the use
of LEAPS for that purpose.

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400 Part Ill: Put Option Strategies
The overriding reason that most strategists sell naked calls is to collect the time
premium before the stock can rise above the striking price. These strategists gener
ally have an opinion about the stock'sdirection, believing that it is perhaps trapped
in atrading range or even headed lower over the short term. This strategy does not
lend itself well to using LEAPS, since it would be difficult to project that the stock
would remain below the strike for so long aperiod of time.
Short LEAPS Instead of Short Stock. Another reason that naked calls are
sold is as astrategy akin to shorting the common stock. In this case, in-the-money
calls are sold. The advantages are threefold:
l. The amount of collateral required to sell the call is less than that required to sell
stock short.
2. One does not have to borrow an option in order to sell it short, although one must
borrow common stock in order to sell it short.
3. An uptick is not required to sell the option, but one is required in order to sell
stock short.
For these reasons, one might opt to sell an in-the-money call instead of shorting
stock.
The profit potentials of the two strategies are different. The short seller of stock
has avery large profit potential if the stock declines substantially, while the seller of
an in-the-money call can collect only the call premium no matter how far the stock
drops. Moreover, the call'sprice decline will slow as the stock nears the strike.
Another way to express this is to say that the delta of the call shrinks from anumber
close to l (which means the call mirrors stock movements closely) to something more
like 0.50 at the strike (which means that the call is only declining half as quickly as
the stock).
Another problem that may occur for the call seller is early assignment, atopic
that is addressed shortly. One should not attempt this strategy if the underlying stock
is not borrowable for ordinary short sales. If the underlying stock is not available for
borrowing, it generally means that extraneous forces are at work; perhaps there is atender offer or exchange offer going on, or some form of convertible arbitrage is tak
ing place. In any case, if the underlying stock is not borrowable, one should not be
deluded into thinking that he can sell an in-the-money call instead and have aworry
free position. In these cases, the call will normally have little or no time premium and
may be subject to early assignment. If such assignment does occur, the strategist will
become short the stock and, since it is not borrowable, will have to cover the stock.
At the least, he will cost himself some commissions by this unprofitable strategy; and
at worst, he will have to pay ahigher price to buy back the stock as well.

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