especially attractive if interest rates for the
differential were high. Unfortunately, those high rates would present something of a
catch-22 because, as was shown earlier, higher rates will cause the LEAPS to be more
expensive.
In this margin strategy, one has the risk of not participating in cash dividend
increases or specials as the stockholder who substitutes does. But the other concerns
of the stockholder, such as taxes, are not pertinent here. Again, these specific calcu
lations only apply if the stock were to be held for the entire year. Adjustments would
have to be made if the holding period envisioned is shorter.
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't have 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 a striking
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 a real 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 a cost-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.
Chapter 25: LEAPS 381
In summary, a prospective 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 a special 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 a price of 39½. What if he had bought a LEAPS put instead?
Forgetting the price of the put for a moment, concentrate on what the strategy would
accomplish. He would be protected from a large loss on the downside since he owns
the put, and he could participate in upside appreciation since he still owns the stock.
Isn't this what the substitution strategy was trying to accomplish? Yes, it is. In this
strategy, only one commission is paid- that being on a fairly 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 a call or buying a put is a relatively sim
ple one. First, do the calculations as they were performed in the initial example
above. That example showed that the stockholder's cost would be $102 to substitute
the LEAPS call for the stock, and such a substitution would protect him at a price of
39½. In effect, he is paying $152 for a LEAPS put with a strike 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 a position 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 a call, or continue to hold his stock and buy
a put 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
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 a smarter purchase than the
stock itself, in-the-money puts may sometimes be a better purchase than shorting the
common stock. Recall that either the put purchase or the short sale of stock is a bear
ish strategy, generally implemented by someone who expects the stock to decline in
price. The strategist knows, however, that short stock is a component 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


ase than shorting the
common stock. Recall that either the put purchase or the short sale of stock is a bear
ish strategy, generally implemented by someone who expects the stock to decline in
price. The strategist knows, however, that short stock is a component 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 a viable 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
Chapter 25: LEAPS 383
buyer to less risk of time decay on a daily 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 a normal short-term equity option and time will begin to take a more 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 a pittance 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 a rapid rate. This gives the LEAPS holder a
chance 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's timing of the option pur
chase does not have to be as exact as that for shorter-term option buying. This can be
a great psychological advantage as well as a strategic 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 a reason
able portion of his initial purchase price because of the slow percentage rate of decay.
Do not be deluded into believing that LEAPS don't decay 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 a
striking price of 60. The daily decay of this call with respect to time will be minus-
384
TABLE 25-2.
Daily percent time value decay.
Months remaining At-the-money
24 .12
18 .14
12 .19
9 .22
6 .27
3 .60
2 .73
1.27
2 wks 3.33
FIGURE 25-4.
Daily percent time value decay.
125
100
20% Out-of-the-Money
0
0
~
~ 75 -
~
0
c @ 50
8:
25
0
3
At-the-Money
6 9 12 15
Part Ill: Put Option Strategies
Percent Decay
20% Out-of-the-money
.18
.27
.55
.76
1.18
3.57
4.43
LEAPS
18 21 24
Months Remaining
cule; it will take about a week for even an eighth of a point to be lost due to time.
However, if the option is held for six months and nothing else happens, the LEAPS
call will be selling for about 6. Thus, it will have lost 25% of its value i

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6 9 12 15
Part Ill: Put Option Strategies
Percent Decay
20% Out-of-the-money
.18
.27
.55
.76
1.18
3.57
4.43
LEAPS
18 21 24
Months Remaining
cule; it will take about a week for even an eighth of a point to be lost due to time.
However, if the option is held for six months and nothing else happens, the LEAPS
call will be selling for about 6. Thus, it will have lost 25% of its value if the stock
remains around 60 at the end of six months.
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 a longer-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.
A few sample prices may help to demonstrate just how powerful the effects of
rates and volatilities are, and how they can be a friend 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 a low 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 a profit 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's investment. Table
25-3 shows where volatility would have to be or where short-term rates would have
386 Part Ill: Put Option Strategies
TABLE 25-3.
Factors necessary for January 2-year LEAPS to be = 14.
Stock price After l month
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 a
jump 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 a month, 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 a strategy.
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 expira


pter,
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 a comparable 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~e approximately 5% in-the-money. If
the options are more in-the-money than that, then the LEAPS call has a lower 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 a small movement in the stock. With LEAPS, how
ever, there is much less discrepancy in the amount of option price movement that
will occur.
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 a gain of 17/s
in the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro
jected by multiplying the call's delta times 3 (the expected stock move, in points).
Thus, there is a large 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 a discrepancy 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
Chapter 25: LEAPS 389
delta indicate that the January 90 LEAPS will move by a larger 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 a little 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't move 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't behave 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
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
Janu


nths
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 a gain of F/s
in the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro
jected by multiplying the call's delta times 3 (the expected stock move, in points).
Thus, there is a large 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 a discrepancy 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
Chapter 25: LEAPS 389
delta indicate that the January 90 LEAPS will move by a larger 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 a little 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't move 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't behave 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
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 a one-point move in the underlying
stock. LEAPS put buyers who want to speculate on a stock's downward 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't mirror 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't need 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
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 a higher 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


PS.
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 a higher 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 a short-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 a call against it in order to attain a par
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 a dividend 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 a smaller cash investment, since he is sell
ing a more 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
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 a much higher net return if exercised, again because he
wrote a more 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 a similar 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 a higher 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
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 a covered write on margin if the investor
is using a margin account. The steps above are the mechanical ones that a covered
writer should go through in order to see how the short-term write compares to the
longer-term LEAPS write. Analyzing them is often a less 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 a somewhat 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 a year and a half 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 extre


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 a false 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's attitude toward long-term investing will be a
major 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 a temporary expansion of option premium in the short-term XYZ calls that
should be exploited, and he would not really want to be a long-term holder of the
stock, then he would choose the short-term covered write.
394 Part Ill: Put Option Strategies
Downside Protection. The actual downside break-even point might enter into
one's thinking as well. A downside break-even point of 40.3 is available by using the
LEAPS write, and that is a known 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. A problem arises if XYZ falls to 40 quickly. If that happened,
the LEAPS call would still have a significant 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 a loss, not a break-even situation.
The short-term write offers downside protection only to a stock 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 a lower
striking price, thereby locking in a smaller profit ( or possibly even a loss) if premium
levels shrink. The concepts of rolling down are described in detail in Chapter 2.
A further 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 a lower 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 a means of bringing in a healthy
premium even though he is rolling down. It is true that a large premium could be
brought into the account. But remember that by doing so, one is committing himself
to sell the stock at a lower 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 a longer period of time.
Consequently, one should not always roll dm,vn into an option with a longer maturi
ty. Instead, he should carefully analyze whether he wants to be committed for an
even longer time to a position in which the underlying common stock is declining.
To summarize, the large absolute premiums available in LEAPS calls may make
a covered write of those calls seem unusually attractive. However, one should calcu
late the returns available and decide whether a short-term write might not serve his
purpose as well. Even though the large LEAPS premium might reduce the initial
investment to a mere pittance, be aware that this creates a great amount of leverage,
and leverage can be a dangerous thing.
The large amount of downside protection offered by the LEAPS call is real, but
if the stock falls quickly, there would definitely be a loss 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 a lower price than he had originally intended.
Chapter 25: LEAPS 39S
✓,,FREE" COVERED CALL WRITES
In Chapter 2, a strategy of writing expensive LEAPS options was briefly described.
In this section, a more detailed analysis is offered. A certain type of covered call
write, one in which the call is quite expensive, sometimes attracts traders looking for
a "free ride." To a certain extent, this strategy is something of a free ride. As you
might imagine, though, there can be major problems.
The investment required for a covered 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 a margin account, a cov
ered write could be established for "free." Let's discuss 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 a stock would be
quite volatile.
Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a
2-year LEAPS call with a striking price of 40 is selling for $19. The requirement


all 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 a stock would be
quite volatile.
Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a
2-year LEAPS call with a striking 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 a minimal investment, one could lose a for
tune. In addition, if the stock begins to fall, one's broker is going to want maintenance
margin. He probably wouldn't let the stock slip more than a couple 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't be 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's a total of $38,000. There would also be commissions on the
purchase and the sale.
396 Part Ill: Put Option Strategies
In summary, this is a position 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't
quite accurately state the case for a margined covered call write. When a covered call
is written against the stock, there is a catch: 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 a strike price
of 30, selling for 25 points. One might think that the requirement for a covered call
write would be zero, since the call sells for 50% of the stock price. But that's not 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 a lot 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 a viable 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.
Chapter 25: LEAPS 397
Uncovered Put Selling. Naked put selling is addressed first because, as a strat
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 a naked 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 a
call. 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


s 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 a modicum 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 a dividend 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
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 a better 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
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 a larger premium and one does not have to find a replacement until the longer
term LEAPS put expires. The negative aspect to selling the LEAPS puts is that time
decay won't help much right away and, even if the stock moves higher (which is
ostensibly good for the position), the put won't decline in price by a large 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 a net cost of the striking price less the pre
mium they received from the sale of the put. If they don't get assigned, they get to
keep a profit equal to the premium they received when they first sold the put.
Generally, a person would only sell puts in this manner on a stock that he had faith
in, so that if he was assigned on the put, he would view that as a buying opportunity
in the underlying stock. This strategy does not lend itself well to LEAPS. Since the
LEAPS puts will carry a significant 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 a stock
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.
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
all


e 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.
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's direction, believing that it is perhaps trapped
in a trading 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 a period of time.
Short LEAPS Instead of Short Stock. Another reason that naked calls are
sold is as a strategy 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 a very 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's price 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 a number
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, a topic
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 a
tender 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 a worry
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 a higher price to buy back the stock as well.
Chapter 25: LEAPS 401
LEAPS calls may help to alleviate this problem. Since they are such long-term
calls, they are likely to have some time value premium in them. In-the-money calls that
have time value premium are not normally assigned. As an alternative to shorting a
stock that is not borrowable, one might try to sell an in-the-money LEAPS call, but
only if it has time value premium remaining. Just because the call has a long time
remaining until expiration does not mean that it must have time value premium, as will
be seen in the following discussion. Finally, if one does sell the LEAPS call, he must
realize that if the stock drops, the LEAPS call will not follow it completely. As the stock
nears the strike, the amount of time value premium will build up to an even greater
level in the LEAPS. Still, the naked call seller would make some profit in that case, and
it presents a better alternative than not being able to sell the stock short at all.
Early Assignment. An American-style option is one that can be exercised at any
time during its life. All listed equity options, LEAPS included, are of this variety.
Thus, any in-the-money option that has been sold may become subject to early
assignment. The clue to whether early assignment is imminent is whether there is
time value premium in the option. If the option has no time value premium - in other
words, it is trading at parity or at a discount then assignment may be close at hand.
The option writer who does not want to be assigned would want to cover the option
when it no longer carries time premium.
LEAPS may be subject to early assignment as well. It is possible, albeit far less
likely, that a long-term option would lose all of its time value premium and therefore
be subject to early assignment. This would certainly happen if the underlying stock
were being taken over and a tender off er were coming to fruition. However, it may
also occur because of an impending dividend payment, or more specifically, because
the stock is about to go ex-dividend. Recall that the call owner, LEAPS calls includ
ed, is not entitled to any dividends paid by the underlying stock. So if the call owner
wants the dividend, he exercises his call on the day before the stock goes ex-dividend.
This makes him an owner of the common stock just in the nick of time to get the div
idend.
What economic factors motivate him to exercise the call? If there is any time
value premium at all in the call, the call holder would be better off selling the call in
the open market and then purchasing the stock in the open market as well. In this
manner, he would still get the dividend, but he would get a better price for his call
when he sold it. If, however, there is no time value premium in the call, he does not
have to bother with two transactions in the open market; he merely exercises his call
in order to buy stock.
All well and good, but what makes the call sell at parity before expiration


ck in the open market as well. In this
manner, he would still get the dividend, but he would get a better price for his call
when he sold it. If, however, there is no time value premium in the call, he does not
have to bother with two transactions in the open market; he merely exercises his call
in order to buy stock.
All well and good, but what makes the call sell at parity before expiration? It has
to do with the arbitrage that is available for any call option. In this case, the arbitrage
402 Part Ill: Put Option Strategies
is not the simple discount arbitrage that was discussed in Chapter l when this topic
was covered. Rather, it is a more complicated form that is discussed in greater detail
in Chapter 28. Suffice it to say that if the dividend is larger than the interest that can
be earned from a credit balance equal to the striking price, then the time value pre
mium will disappear from the call.
Example: XYZ is a $30 stock and about to go ex-dividend 50 cents. The prevailing
short-term interest rate is 5% and there are LEAPS with a striking price of 20.
A 50-cent quarterly dividend on a striking price of 20 is an annual dividend rate
(on the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs
economically cannot pay out 10% for dividends and earn 5% for their credit balances.
In this situation, the LEAPS call would lose its time value premium and would
be a candidate for early exercise when the stock goes ex-dividend.
In actual practice, the situation is more complicated than this, because the price
of the puts comes into play; but this example shows the general reasoning that the
arbitrageur must go through.
Certain arbitrageurs construct positions that allow them to earn interest on a
credit balance equal to the striking price of the call. This position involves being short
the underlying stock and being long the call. Thus, when the stock goes ex-dividend,
the arbitrageur will owe the dividend. If, however, the amount of the dividend is
more than he vvill earn in interest from his credit balance, he will merely exercise his
call to cover his short stock. This action will prevent him from having to pay out the
dividend.
The arbitrageur's exercise of the call means that someone is going to be
assigned. If you are a writer of the call, it could be you. It is not important to under
stand the arbitrage completely; its effect will be reflected in the marketplace in the
form of a call trading at parity or a discount. Thus, even a LEAPS call with a sub
stantial anwunt of time rernaining may be assigned if it is trading at parity.
STRADDLE SELLING
Straddle selling is equivalent to ratio writing and is a strategy whereby one attempts
to sell ( overpriced) options in order to produce a range of stock prices within which
the option seller can profit. The strategy often involves follow-up action as the stock
moves around, and the strategist feels that he must adjust his position in order to pre
vent large losses. LEAPS puts and calls might be used for this strategy. However,
their long-term nature is often not conducive to the aims of straddle selling.
First, consider the effect of time decay. One might normally sell a three-month
straddle. If the stock "behaves" and is relatively unchanged after two months have
Chapter 25: LEAPS 403
passed, the straddle seller could reasonably expect to have a profit of about 40% of
the original straddle price. However, if one had sold a 2-year LEAPS straddle, and
the stock were relatively unchanged after two months, he would only have a profit of
about 7% of the original sale price. This should not be surprising in light of what has
been demonstrated about the decaying of long-term options. It should make the
straddle seller somewhat leery of using LEAPS, however, unless he truly thinks the
options are overpriced.
Second, consider follow-up action. Recall that in Chapter 20, it was shown that
the bane of the straddle seller was the whipsaw. A whipsaw occurs when one makes
a follow-up protective action on one side (for instance, he does something bullish
because the underlying stock is rising and the short calls are losing money), only to
have the stock reverse and come crashing back down. Obviously, the more time left
until expiration, the more likely it is that a whipsaw will occur after any follow-up
action, and the more expensive it will be, since there will be a lot of time value pre
mium left in the options that are being repurchased. This makes LEAPS straddle
selling less than attractive.
LEAPS straddles may look expensive because of their large absolute price, and
therefore may appear to be attractive straddle sale candidates. However, the price is
often justified, and the seller of LEAPS straddles will be fighting sudden stock move
ments without getting much benefit from the passage of time. The best time to sell
LEAPS straddles is when short-term rates are high and volatilities are high as well
(i.e., the options are overpriced). At least, in those cases, the seller will derive some
real benefit if rates or volatilities should drop.
SPREADS USING LEAPS
Any of the spread strategies previously discussed can be implemented with LEAPS
as well, if one desires. The margin requirements are the same for LEAPS spreads as
they are for ordinary equity option spreads. One general category of spread lends
itself well to using LEAPS: that of buying a longer-term option and selling a short
term one. Calendar spreads, as well as diagonal spreads, fall into that category.
The combinations are myriad, but the reasoning is the same. One wants to own
the option that is not so subject to time decay, while simultaneously selling the
option that is quite subject to time decay. Of course, since LEAPS are long-term and
therefore expensive, one is generally taking on a large debit in such a spread and
may have substantial risk if the stock performs adversely. Other risks may be


inations are myriad, but the reasoning is the same. One wants to own
the option that is not so subject to time decay, while simultaneously selling the
option that is quite subject to time decay. Of course, since LEAPS are long-term and
therefore expensive, one is generally taking on a large debit in such a spread and
may have substantial risk if the stock performs adversely. Other risks may be pres
ent as well. As a means of demonstrating these facts, let us consider a simple bull
spread using calls.
404 Part Ill: Put Option Strategies
Example: The following prices exist in the month of January:
XYZ: 105
April 100 call: 10 1/2
April 110 call: 5 1/2
January (2-year) 100 call: 26
January (2-year) 110 call: 21 1/2
An investor is considering a bull spread in XYZ and is unsure about whether to use
the short-term calls, the LEAPS calls, or a mixture. These are his choices:
Short-term bull spread:
Diagonal bull spread:
LEAPS bull spread:
Buy April 100@ 101/2
Sell April 110@ 51/2
Net Debit: $500
Buy January LEAPS 100 @ 26
Sell April 110@ 51/2
Net Debit: $2,050
Buy January LEAPS 1 00 @ 26
Sell January LEAPS 110@ 21 1/2
Net Debit: $450
Notice that the debit paid for the LEAPS spread is slightly less than that of the short
term bull spread. This means that they have approximately the same profit potential
at their respective expiration dates. However, the strategist is more concerned with
how these compare directly with each other. The obvious point in time to make this
comparison is when the short-term options expire.
Figure 25-7 shows the profitability of these three positions at April expiration.
It was assumed that all of the following were the same in April as they had been in
January: volatility, short-term rates, and dividend payout.
Note that the short-term bull spread has the familiar profit graph from Chapter
7, making its maximum profit over 110 and taking its maximum loss below 100. (See
Table 25-4.)
The LEAPS spread doesn't generate much of either a profit or a loss in only
three months' time. Even if XYZ rises to 120, the LEAPS bull spread will have only
a $150 profit. Conversely, if XYZ falls to 80, the spread loses only about $200. This
price action is very typical for long-term bull spreads when both options have a sig
nificant amount of time premium remaining in them.
Chapter 25: LEAPS
FIGURE 25-7.
Bull spread comparison at April expiration.
Stock Price
405
The diagonal spread is different, however. Typically, the maximum profit poten
tial of a bull spread is the difference in the strikes less the initial debit paid. For this
diagonal spread, that would be $1,000 minus $2,050, a loss! Obviously, this simple
formula is not applicable to diagonal spreads, because the purchased option still has
time value premium when the written option expires. The profit graph shows that
indeed the diagonal spread is the most bullish of the three. It makes its best profit at
the strike of the written option - a standard procedure for any spread - and that prof
it is greater than either of the other two spreads at April expiration ( under the sig-
TABLE 25-4.
Bull spread comparison at April expiration.
Stock Price Short-Term Diagonal LEAPS
80 -500 -1, 100 -200
90 -500 - 600 -150
100 -500 50 - 25
110 500 750 50
120 500 550 150
140 500 150 250
160 500 50 350
180 500 - 350 450
406 Part Ill: Put Option Strategies
nificant assumption that volatility and interest rates are unchanged). If XYZ trades
higher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were
to trade at a very high price, the diagonal spread would actually have a loss (see Table
25-4). Whenever the purchased LEAPS call loses its time value premium, the diag
onal spread will not perform as well.
If the common stock drops in price, the diagonal spread has the greatest risk in
dollar terms but not in percentage terms, because it has the largest initial debit. If
XYZ falls to 80 in three months, the spread will lose about $1,100, just over half the
initial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini
tial debit, which is only $500, at that same point in time.
The diagonal spread presents an opportunity to earn more money if the under
lying common is near the strike of the written option when the written option expires.
However, if the common moves a great deal in either direction, the diagonal spread
is the worst of the three. This means that the diagonal spread strategy is a neutral
strategy: One wants the underlying common to remain near the written strike until
the near-term option expires. This is a true statement even if the diagonal spread is
under the guise of a bullish spread, as in the previous example.
Many traders are fond of buying LEAPS and selling an out-of-the-money near
term call as a hedge. Be careful about doing this. If the underlying common rises too
fast and/or interest rates fall and/or volatility decreases, this could be a poor strategy.
There is really nothing quite as psychologically damaging as being right about the
stock, but being in the wrong option strategy and therefore losing money. Consider
the above examples. Ostensibly, the spreader was bullish on XYZ; that's why he chose
bull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three
months, the diagonal spreader would have lost money. He couldn't have been happy
- no one would be. This is something to keep in mind when diagonalizing a LEAPS
spread.
The deltas of the options involved in the spread will give one a good clue as to
how it is going to perform. Recall that a short-term, in-the-money option acquires a
rather high delta, especially as expiration draws nigh. However, an in-the-money
LEAPS call will not have an extremely high delta, because of the vast amount of time
remaining. Thus, one is short an option with a high delta and long an option with a
smaller delta. These deltas in


ll give one a good clue as to
how it is going to perform. Recall that a short-term, in-the-money option acquires a
rather high delta, especially as expiration draws nigh. However, an in-the-money
LEAPS call will not have an extremely high delta, because of the vast amount of time
remaining. Thus, one is short an option with a high delta and long an option with a
smaller delta. These deltas indicate that one is going to lose money if the underlying
stock rises in price. Consider the following situation:
XYZ Stock, 120:
Call
Long 1 January LEAPS 100 call:
Short 1 April 110 call:
Position Delta
0.70
-0.90
Chapter 25: LEAPS 401
At this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20
cents, since the delta of the short option is 0.20 greater than the delta of the long
option.
This phenomenon has ramifications for the diagonal spreader of LEAPS. If the
two strike prices of the spread are too close together, it may actually be possible to
construct a bull spread that loses money on the upside. That would be very difficult
for most traders to accept. In the above example, as depicted in Table 25-4, that's
what happens. One way around this is to widen the strike prices out so that there is
at least some profit potential, even if the stock rises dramatically. That may be diffi
cult to do and still be able to sell the short-term option for any meaningful amount
of premium.
Note that a diagonal spread could even be considered as a substitute for a cov
ered write in some special cases. It was shown that a LEAPS call can sometimes be
used as a substitute for the common stock, with the investor placing the difference
between the cost of the LEAPS call and the cost of the stock in the bank (or in T
bills). Suppose that an investor is a covered writer, buying stock and selling relative
ly short-term calls against it. If that investor were to make a LEAPS call substitution
for his stock, he would then have a diagonal bull spread. Such a diagonal spread
would probably have less risk than the one described above, since the investor pre
sumably chose the LEAPS substitution because it was "cheap." Still, the potential
pitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one
is a covered writer, this does not necessarily mean that he can substitute LEAPS calls
for the long stock without taking care. The resulting position may not resemble a cov
ered write as much as he thought it would.
The "bottom line" is that if one pays a debit greater than the difference in the
strike prices, he may eventually lose money if the stock rises far enough to virtually
eliminate the time value premium of both options. This comes into play also if one
rolls his options down if the underlying stock declines. Eventually, by doing so, he
may invert the strikes - i.e., the striking price of the written option is lower than the
striking price of the option that is owned. In that case, he will have locked in a loss if
the overall credit he has received is less than the difference in the strikes - a quite
likely event. So, for those who think this strategy is akin to a guaranteed profit, think
again. It most certainly is not.
Backspreads. LEAPS may be applied to other popular forms of diagonal spreads,
such as the one in which in-the-money, near-term options are sold, and a greater quan
tity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was
referred to as a diagonal backspread in Chapter 14.) This is an excellent strategy, and
408 Part Ill: Put Option Strategies
a LEAPS may be used as the long option in the spread. Recall that the object of the
spread is for the stock to be volatile, particularly to the upside if calls are used. If that
doesn't happen, and the stock declines instead, at least the premium captured from
the in-the-money sale will be a gain to offset against the loss suffered on the longer
term calls that were purchased. The strategy can be established with puts as well, in
which case the spreader would want the underlying stock to fall dramatically while the
spread was in place.
Without going into as much detail as in the examples above, the diagonal back
spreader should realize that he is going to have a significant debit in the spread and
could lose a significant portion of it should the underlying stock fall a great deal in
price. To the upside, his LEAPS calls will retain some time value premium and will
move quite closely with the underlying common stock. Thus, he does not have to buy
as many LEAPS as he might think in order to have a neutral spread.
Example: XYZ is at 105 and a spreader wants to establish a backspread. Recall that
the quantity of options to use in a neutral strategy is determined by dividing the
deltas of the two options. Assume the following prices and deltas exist:
Option
April 100 call
July 110 call
January (2-year) LEAPS 100 call
XYZ: 105 in January
Price
8
5
15
Delta
0.75
0.50
0.60
Two backspreads are available with these options. In the first, one would sell the
April 100 calls and buy the July llO calls. He would be selling 3-month calls and buy
ing 6-month calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be
bought for every 2 sold. Thus, a neutral spread would be:
Buy 6 July 110 calls
Sell 4 April l 00 calls
As a second alternative, he might use the LEAPS as the long side of the spread; he
would still sell the April 100 calls as the short side of the spread. In this case, his neu
tral ratio would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be:
Buy 5 January LEAPS 110 calls
Sell 4 April 100 calls
Chapter 25: LEAPS 409
Thus, a neutral backspread involving LEAPS requires buyingfewer calls than a neu
tral backspread involving a 6-rnonth option on the long side. This is because the delta
of the LEAPS call is larger. The significant point here is that, because of the time
value retention


or 5 to 4. The resulting neutral spread would be:
Buy 5 January LEAPS 110 calls
Sell 4 April 100 calls
Chapter 25: LEAPS 409
Thus, a neutral backspread involving LEAPS requires buyingfewer calls than a neu
tral backspread involving a 6-rnonth option on the long side. This is because the delta
of the LEAPS call is larger. The significant point here is that, because of the time
value retention of the LEAPS call, even when the stock moves higher, it is not nec
essary to buy as many. If one does not use the deltas, but merely figures that 3 to 2
is a good ratio for any diagonal backspread, then he will be overly bullish if he uses
LEAPS. That could cost him if the underlying stock declines.
Calendar Spreads. LEAPS may also be used in calendar spreads - spreads in
which the striking price of the longer-term option purchased and the shorter-term
option sold are the same. The calendar spread is a neutral strategy, wherein the
spreader wants the underlying stock to be as close as possible to the striking price
when the near-term option expires. A calendar spread has risk if the stock moves too
far away from the striking price (see Chapters 9 and 22). Purchasing a LEAPS call
increases that risk in terms of dollars, not percentage, because of the larger debit that
one must spend for the spread.
Simplistically, calendar spreads are established with equal quantities of options
bought and sold. This is often not a neutral strategy in the true sense. As was shown
in Chapter 9 on call calendar spreads, one may want to use the deltas of the two
options to establish a truly neutral calendar spread, particularly if the stock is not ini
tially right at the striking price. Out-of-the-money, one would sell more calls than he
is buying. Conversely, in-the-money, one would buy more calls than he is selling.
Both strategies statistically have merit and are attractive. When using LEAPS deltas
to construct the neutral spread, one need generally buy fewer calls than he might
think, because of the higher delta of a LEAPS call. This is the same phenomenon
described in the previous example of a diagonal backspread.
SUMMARY
LEAPS are nothing more than long-term options. They are usable in a wide variety
of strategies in the same way that any option would be. Their margin and investment
requirements are similar to those of the more familiar equity options. Both LEAPS
puts and calls are traded, and there is a secondary market for them as well.
There are certain differences between the prices of LEAPS and those of short
er-term options, but the greatest is the relatively large effect that interest rates and
dividends have on the price of LEAPS, because LEAPS are long-term options.
Increases in interest rates will cause LEAPS to increase in price, while increases in
dividend payout will cause LEAPS calls to decrease in price and LEAPS puts to
410 Part Ill: Put Option Strategies
increase in price. As usual, volatility has a major effect on the price of an option, and
LEAPS are no exception. Even small changes in the volatility of the underlying com
mon stock can cause large price differences in a two-year option. The rate of decay
due to time is much smaller for LEAPS, since they are long-term options. Finally, the
deltas of LEAPS calls are larger than those of short-term calls; conversely, the deltas
of LEAPS puts are smaller.
Several common strategies lend themselves well to the usage of LEAPS. A
LEAPS may be used as a stock substitute if the cash not invested in the stock is
instead deposited in a CD or T-bill. LEAPS puts can be bought as protection for
common stock. Speculative option buyers will appreciate the low rate of time decay
of LEAPS. LEAPS calls can be written against common stock, thereby creating a
covered write, although the sale of naked LEAPS puts is probably a better strategy
in most cases. Spread strategies with LEAPS may be viable as well, but the spreader
should carefully consider the ramifications of buying a long-term option and selling
a shorter-term one against it. If the underlying stock moves a great distance quickly,
the spread strategy may not perform as expected.
Overall, LEAPS are not very different from the shorter-term options to which
traders and investors have become accustomed. Once these investors become famil
iar with the way these long-term options are affected by the various factors that
determine the price of an option, they will consider the use of LEAPS as an integral
part of a strategic arsenal.
Additional
Considerations

Buying Options
and Treasury Bills
Numerous strategies have been described, ranging from the simple to the complex.
Each one has advantages, but there are disadvantages as well. In fact, some of them
may be too complex for the average investor to seriously consider implementing. The
reader may feel that there should be an easier answer. Isn't there a strategy that
might not require such a large investment or so much time spent in monitoring the
position, but would still have a chance of returning a reasonable profit? In fact, there
is a strategy that has not yet been described, a strategy considered by some experts
in the field of mathematical analysis to be the best of them all. Simply stated, the
strategy consists of putting 90% of one's money in risk-free investments (such as
short-term Treasury bills) and buying options with the remaining 10% of one's funds.
It has previously been pointed out that some of the more attractive strategies
are those that involve small levels of risk with the potential for large profits. Usually,
these types of strategies inherently have a rather large frequency of small losses, and
a small probability of realizing large gains. Their advantage lies in the fact that one or
two large profits can conceivably more than make up for numerous small losses. This
Treasury bill/option strategy is another strategy of this type.
HOW THE TREASURY BILL/OPTION STRATEGY


l for large profits. Usually,
these types of strategies inherently have a rather large frequency of small losses, and
a small probability of realizing large gains. Their advantage lies in the fact that one or
two large profits can conceivably more than make up for numerous small losses. This
Treasury bill/option strategy is another strategy of this type.
HOW THE TREASURY BILL/OPTION STRATEGY OPERATES
Although there are certain details involved in operating this strategy, it is basically a
simple one to approach. First, the most that one can lose is 10%, less the interest
earned on the fixed-income portion of his portfolio (the remaining 90% of his assets),
during the life of the purchased options. It is a simple matter to space out one's com-
413
414 Part IV: Additional Considerations
mitments to option purchases so that his overall risk in a one-year period can be kept
down to nearly 10%.
Example: An investor might decide to put 2½% of his money into three-month
option purchases. Thus, in any one year, he would be 1isking 10%. At the same time
he would be earning perhaps 6% from the overall interest generated on the fixed
income securities that make up the remaining 90% of his assets. This would keep his
overall risk down to approximately 4.6% per year.
There are better ways to monitor this risk, and they are described shortly. The
potential profits from this strategy are limited only by time. Since one is owning
options - say call options - he could profit handsomely from a large upward move in
the stock market. As with any strategy in which one has limited risk and the poten
tial of large profits, a small number of large profits could offset a large number of
small losses. In actual practice, of course, his profits will never be overwhelming,
since only approximately 10% of the money is committed to option purchases.
In total, this strategy has greatly reduced 1isk with the potential of making
above-average profits. Since the 10% of the money that is invested in options gives
great leverage, it might be possible for that portion to double or triple in a short time
under favorable market conditions. This strategy is something like owning a convert
ible bond. A convertible bond, since it is convertible into the common stock, moves
up and down in price with the price of the underlying stock. However, if the stock
should fall a great deal, the bond will not follow it all the way down, because eventu
ally its yield will provide a "floor" for the price.
A strategy that is not used very often is called the "synthetic convertible bond."
One buys a debenture and a call option on the same stock. If the stock rises in price,
the call does too, and so the combination of the debenture and the call acts much like
a convertible bond would to the upside. If, on the other hand, the stock falls, the call
will expire worthless; but the investor will retain most of his investment, because he
will still have the debenture plus any interest that the bond has paid.
The strategy of placing 90% of one's money into risk-free, interest-bearing cer
tificates and buying options with the remainder is superior to the convertible bond
or the "synthetic convertible bond," since there is no risk of price fluctuation in the
largest portion of the investment.
The Treasury bill/option strategy is fairly easy to operate, although one does
have to do some work every time new options are purchased. Also, periodic adjust
ments need to be made to keep the level of risk approximately the same at all times.
As for which options to buy, the reader may recall that specifications were outlined
in Chapters 3 and 16 on how to select the best option purchases. These criteria can
be summarized briefly as follows:
Chapter 26: Buying Options and Treasury Bills 415
1. Assume that each underlying stock can advance or decline in accordance with its
volatility over a fixed time period (30, 60, or 90 days).
2. Estimate the call prices after the advance, or put prices after the decline.
3. Rank all potential purchases by the highest reward opportunity.
The user of this strategy need only be interested in those option purchases that
provide the highest reward opportunity under this ranking method. In the previous
chapters on option buying, it was mentioned that one might want to look at the
risk/reward ratios of his potential option purchases in order to have a more conser
vative list. However, that is not necessary in the Treasury bill/option strategy, since
the overall risk has already been limited. A ranking of option purchases via the fore
going criteria will generally give a list of at- or slightly out-of-the-money options.
These are not necessarily "underpriced" options; although if an option is truly under
priced, it will have a better chance of ranking higher on the selection list than one
that is "overpriced."
A list of potential option purchases that is constructed with criteria similar to
those outlined above is available from many data services and brokerage firms. The
strategist who is willing to select his option purchases in this manner will find that he
does not have to spend a great deal of time on the selection process. The reader
should note that this type of option purchase ranking completely ignores the outlook
for the underlying stock. If one would rather make his purchases based on an outlook
for the underlying stock - preferably a technical outlook - he will be forced to spend
more time on his selection process. Although this may be appealing to some
investors, it will probably yield worse results in the long run than the previously
described unbiased approach to option purchases, unless the strategist is extremely
adept at stock selection.
KEEPING THE RISK LEVEL EQUAL
The second function that the strategist has to perform in this Treasury bill/option
strategy is to keep his risk level approximately equal at all times.
Example: An investor starts the s


ill probably yield worse results in the long run than the previously
described unbiased approach to option purchases, unless the strategist is extremely
adept at stock selection.
KEEPING THE RISK LEVEL EQUAL
The second function that the strategist has to perform in this Treasury bill/option
strategy is to keep his risk level approximately equal at all times.
Example: An investor starts the strategy with $90,000 in Treasury bills (T-bills) and
$10,000 in option purchases. After some time has passed, the option purchases may
have worked out well and perhaps he now has $90,000 in T-bills plus $30,000 worth
of options, plus interest from the T-bills. Obviously, he no longer has 90% of his
money in fixed-income securities and 10% in option purchases. The ratio is now 75%
in T-bills and 25% in option purchases. This is too risky a ratio, and the strategist
must consequently sell some of his options and buy T-bills with the proceeds. Since
his total assets are $120,000 currently, he must sell out $18,000 of options to bring his
416 Part IV: Additional Considerations
option investment down from the current $30,000 figure to $12,000, or 10% of his
total assets. If one fails to adhere to this readjustment of his funds after profits are
made, he may eventually lose those profits. Since options can lose a great percentage
of their worth in a short time pe1iod, the investor is always running the risk that the
option portion of his investment may be nearly wiped out. If he has kept all his prof
its in the option portion of his strategy, he is constantly risking nearly all of his accu
mulated profits, and that is not wise.
One must also adjust his ratio of T-bills to options after losses occur.
Example: In the first year, the strategist loses all of the $10,000 he originally placed
in options. This would leave him with total assets of $90,000 plus interest (possibly
$6,000 of interest might be earned). He could readjust to a 90:10 ratio by selling out
some of the T-bills and using the proceeds to buy options. If one follows this strate
gy, he will be risking 10% of his funds each year. Thus, a series of loss years could
depreciate the initial assets, although the net losses in one year would be smaller than
10% because of the interest earned on the T-bills. It is recommended that the strate
gist pursue this method of readjusting his ratios in both up and down markets in
order to constantly provide himself with essentially similar risk/reward opportunities
at all times.
The individual can blend the option selection process and the adjustment of the
T-bill/option ratio to fit his individual portfolio. The larger portfolio can be diversi
fied into options \vith differing holding periods, and the ratio adjustments can be
made quite frequently, perhaps once a month. The smaller investor should concen
trate on somewhat longer holding periods for his options, and would adjust the ratio
less often. Some examples might help to illustrate the way in which both the large
and small strategist might operate. It should be noted that this T-bill/option strategy
is quite adaptable to fairly small sums of money, as long as the 10% that is going to
be put into option purchases allows one to be able to participate in a reasonable man
ner. A tactic for the extremely small investor is also described below.
ANNUALIZED RISK
Before getting into portfolio size, let us describe the concept of annualized risk.
One might want to purchase options with the intent of holding some of them for 30
days, some for 90 days, and some for 180 days. Recall that he does not want his
option purchases to represent more than 10% annual risk at any time. In actual
practice, if one purchases an option that has 90 days of life, but he is planning to
hold the option only 30 days, he will most likely not lose 100% of his investment in
Chapter 26: Buying Options and Treasury Bills 417
the 30-day period. However, for purposes of computing annualized risk easily, the
assumption that will be made is that the risk during any holding period is 100%,
regardless of the length of time remaining in the life of the option. Thus, a 30-day
option purchase represents an annualized risk of 1,200% (100% risk every 30 days
times twelve 30-day periods in one year). Ninety-day purchases have 400% annual
ized risk, and 180-day purchases have 200% annualized risk. There is a multitude
of ways to combine purchases in these three holding periods so that the overall risk
is 10% annualized.
Example: An investor could put 2½% of his total money into 90-day purchases four
times a year. That is, 2½% of his total assets are being subjected to a 400% annual
ized risk; 400% times 2½% equals 10% annualized risk on the total assets. Of course,
the remainder of the assets would be placed in risk-free, income-bearing securities.
Another of the many combinations might be to place 1 % of the total assets in 90-day
purchases and also place 3% of the total assets in 180-day purchases. Thus, 1 % of
one's total money would be subjected to a 400% annual risk and 3% would be sub
jected to a 200% annual risk (.01 times 400 plus .03 times 200 equals 10% annualized
risk on the entire assets). If one prefers a formula, annualized risk can be computed
as:
A al. d • k • r 1. Percent of total 360 nnu 1ze ns on entire portro 10 = d x assets investe Holding period
If one is able to diversify into several holding periods, the annualized risk is merely
the sum of the risks for each holding period.
With this information in mind, the strategist can utilize option purchases of 1
month, 3 months, and 6 months, preferably each generated by a separate computer
analysis similar to the one described earlier. He will know how much of his total
assets he can place into purchases of each holding period, because he will know his
annualized risk.
Example: Suppose that a very large investor, or pool of investors, has $1 million com
mitted to this T-bi