: Put Option Strategies
The bullish portion of this combination of calendar spreads would be set up by sell
ing the shorter-term January 70 call for 3 points and simultaneously buying the
longer-term April 70 call for 5 points. This portion of the spread requires a 2-point
debit. The bearish portion of the spread would be constructed using the puts. The
near-term January 60 put would be sold for 2 points, while the longer-term April 60
put would be bought for 3. Thus, the put portion of the spread is a I-point debit.
Overall, then, the combination of the calendar spreads requires a 3-point debit, plus
commissions. This debit is the required investment; no additional collateral is
required. Since there are four options involved, the commission cost will be large.
Again, establishing the spreads in quantity can reduce the percentage cost of com
missions.
Note that all the options involved in this position are initially out-of-the-money.
The stock is below the striking price of the calls and is above the striking price of the
puts. One has sold a near-term put and call combination and purchased a longer-term
combination. For nomenclature purposes, this strategy is called a "calendar combi
nation."
There are a variety of possible outcomes from this position. First, it should be
understood that the risk is limited to the amount of the initial debit, 3 points in this
example. If the underlying stock should rise dramatically or fall dramatically before
the near-term options expire, both the call spread and the put spread will shrink to
nearly nothing. This would be the least desirable result. In actual practice, the spread
would probably have a small positive differential left even after a premature move by
the underlying stock, so that the probability of a loss of the entire debit would be
small.
If the near-term options both expire worthless, a profit will generally exist at
that time.
Example: IfXYZ were still at 65 at January expiration in the prior example, the posi
tion should be profitable at that time. The January call and put would expire worth
less with XYZ at 65, and the April options might be worth a total of 5 points. The
spread could thus be closed for a profit with XYZ at 65 in January, since the April
options could be sold for 5 points and the initial "cost" of the spread was only 3 points.
Although commissions would substantially reduce this 2-point gross profit, there
would still be a good percentage profit on the overall position. If the strategist decides
to take his profit at this time, he would be operating in a conservative manner.
However, the strategist may want to be more aggressive and hold onto the April
combination in hopes that the stock might experience a substantial movement before
those options expire. Should this occur, the potential profits could be quite large.
Chapter 23: Spreads Combining Calls and Puts 347
Example: If the stock were to undergo a very bullish move and rise to 100 before
April expiration, the April 70 call could be sold for 30 points. (The April 60 put would
expire worthless in that case.) Alternatively, if the stock plunged to 30 by April expi
ration, the put at 60 could be sold for 30 points while the call expired worthless. In
either case, the strategist would have made a substantial profit on his initial 3-point
investment.
It may be somewhat difficult for the strategist to decide what he wants to do
after the near-term options expire worthless. He may be torn between taking the lim
ited profit that is at hand or holding onto the combination that he owns in hopes of
larger profits. A reasonable approach for the strategist to take is to do nothing imme
diately after the near-term options expire worthless. He can hold the longer-term
options for some time before they will decay enough to produce a loss in the posi
tion. Referring again to the previous example, when the January options expire
worthless, the strategist then owns the April combination, which is worth 5 points at
that time. He can continue to hold the April options for perhaps 6 or 8 weeks before
they decay to a value of 3 points, even if the stock remains close to 65. At this point,
the position could be closed for a net loss of the .commission costs involved in the var
ious transactions.
As a general rule, one should be willing to hold the combination, even if this
means that he lets a small profit decay into a loss. The reason for this is that one
should give himself the maximum opportunity to realize large profits. He will proba
bly sustain a number of small losses by doing this, but by giving himself the oppor
tunity for large profits, he has a reasonable chance of having the profits outdistance
the losses.
There is a time to take small profits in this strategy. This would be when either
the puts or the calls were slightly in-the-money as the near-term options expire.
Example: IfXYZ moved to 71 just as the January options were expiring, the call por
tion of the spread should be closed. The January 70 call could be bought back for 1
point and the April 70 call would probably be worth about 5 points. Thus, the call
portion of the spread could be "sold" for 4 points, enough to cover the entire cost of
the position. The April 60 put would not have much value with the stock at 71, but it
should be held just in case the stock should experience a large price decline. Similar
results would occur on the put side of the spread if the underlying stock were slight
ly in-the-money, say at 58 or 59, at January expiration. At no time does the strategist
want to risk being assigned on an option that he is short, so he must always close the
portion of the position that is in-the-money at near-term expiration. This is only nec
essary, of course, if the stock has risen above the striking price of the calls or has fall
en below the striking price of the puts.
348 Part Ill: Put Option Strategies
In summary, this is a reasonable str


s the strategist
want to risk being assigned on an option that he is short, so he must always close the
portion of the position that is in-the-money at near-term expiration. This is only nec
essary, of course, if the stock has risen above the striking price of the calls or has fall
en below the striking price of the puts.
348 Part Ill: Put Option Strategies
In summary, this is a reasonable strategy if one operates it over a period of time
long enough to encompass several market cycles. The strategist must be careful not
to place a large portion of his trading capital in the strategy, however, since even
though the losses are limited, they still represent his entire net investment. A varia
tion of this strategy, whereby one sells more options than he buys, is described in the
next chapter.
THE CALENDAR STRADDLE
Another strategy that combines calendar spreads on both put and call options can be
constructed by selling a near-term straddle and simultaneously purchasing a longer
term straddle. Since the time value premium of the near-term straddle will decrease
more rapidly than that of the longer-term straddle, one could make profits on a lim
ited investment. This strategy is somewhat inferior to the one described in the pre
vious section, but it is interesting enough to examine.
Example: Suppose that three months before January expiration, the following prices
exist:
XYZ common: 40
January 40 straddle: 5 April 40 straddle: 7
A calendar spread of the straddles could be established by selling the January 40
straddle and simultaneously buying the April 40 straddle. This would involve a cost
of 2 points, or the debit of the transaction, plus commissions.
The risk is limited to the amount of this debit up until {he time the near-term
straddle expires. That is, even if XYZ moves up in price by a substantial amount or
declines in price by a substantial amount, the worst that can happen is that the dif
ference between the straddle prices shrinks to zero. This could cause one to lose an
amount equal to his original debit, plus commissions. This limit on the risk applies
only until the near-term options expire. If the strategist decides to buy back the near
term straddle and continue to hold the longer-term one, his risk then increases by the
cost of buying back the near-term straddle.
Example: XYZ is at 43 when the January options expire. The January 40 call can now
be bought back for 3 points. The put expires worthless; so the whole straddle was
closed out for 3 points. The April 40 straddle might be selling for 6 points at that
time. If the strategist wants to hold on to the April straddle, in hopes that the stock
might experience a large price swing, he is free to do so after buying back the January
Chapter 23: Spreads Combining Calls and Puts 349
40 straddle. However, he has now invested a total of 5 points in the position: the orig
inal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle.
Hence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi
ration, he would lose the entire 5 points. While the probability of losing the entire 5
points must be considered small, there is a substantial chance that he might lose
more than 2 points his original debit. Thus, he has increased his risk by buying back
the near-term straddle and continuing to hold the longer-term one.
This is actually a neutral strategy. Recall that when calendar spreads were dis
cussed previously, it was pointed out that one establishes a neutral calendar spread
with the stock near the striking price. This is true for either a call calendar spread or
a put calendar spread. This strategy - a calendar spread with straddles is merely the
combination of a neutral call calendar spread and a neutral put calendar spread.
Moreover, recall that the neutral calendar spreader generally establishes the position
with the intention of closing it out once the near-term option expires. He is mainly
interested in selling time in an attempt to capitalize on the fact that a near-term
option loses time value premium more rapidly than a longer-term option does. The
straddle calendar spread should be treated in the same manner. It is generally best
to close it out at near-term expiration. If the stock is near the striking price at that
time, a profit will generally result. To verify this, refer again to the prices in the pre
ceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can
be bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif
ferential between the two straddles has widened to 3 points. Since the original dif
ferential was 2 points, this represents a profit to the strategist.
The maximum profit would be realized if XYZ were exactly at the striking price
at near-term expiration. In this case, the January 40 straddle could be bought back
for a very small fraction and the April 40 straddle might be worth about 5 points. The
differential would have widened from the original 2 points to nearly 5 points in this
case.
This strategy is inferior to the one described in the previous section (the "calen
dar combination"). In order to have a chance for unlimited profits, the investor must
increase his net debit by the cost of buying back the near-term straddle.
Consequently, this strategy should be used only in cases when the near-term straddle
appears to be extremely overpriced. Furthermore, the position should be closed at
near-term expiration unless the stock is so close to the striking price at that time that
the near-term straddle can be bought back for a fractional price. This fractional buy
back would then give the strategist the opportunity to make large potential profits
with only a small increase in his risk. This situation of being able to buy back the near
term straddle at a fractional price will occur very infrequently, much more infre-
350 Part Ill: Put Option Strategi

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


ice at that time that
the near-term straddle can be bought back for a fractional price. This fractional buy
back would then give the strategist the opportunity to make large potential profits
with only a small increase in his risk. This situation of being able to buy back the near
term straddle at a fractional price will occur very infrequently, much more infre-
350 Part Ill: Put Option Strategies
quently than the case in which both the out-of-the-money put and call expire worth
less in the previous strategy. Thus, the "calendar combination" strategy will afford the
spreader more opportunities for large profits, and will also never force him to
increase his risk.
OWNING A ✓,,FREE" COMBINATION (THE ""DIAGONAL
BUTTERFLY SPREAD")
The strategies described in the previous sections are established for debits. This
means that even if the near-term options expire worthless, the strategist still has risk.
The long options he then holds could proceed to expire worthless as well, thereby
leaving him with an overall loss equal to his original debit. There is another strategy
involving both put and call options that gives the strategist the opportunity to own a
"free" combination. That is, the profits from the near-term options could equal or
exceed the entire cost of his long-term options.
This strategy consists of selling a near-term straddle and simultaneously pur
chasing both a longer-term, out-of the-money call and a longer-term, out-of the
money put. This differs from the protected straddle write previously described in that
the long options have a more distant maturity than do the short options.
Example:
XYZ common: 40
April 35 put:
January 40 straddle:
April 45 call:
If one were to sell the short-term January 40 straddle for 7 points and simultaneous
ly purchase the out-of-the-money put and call combination -April 35 put and April
45 call - he would establish a credit spread. The credit for the position is 3 points less
commissions, since 7 points are brought in from the straddle sale and 4 points are
paid for the out-of-the-money combination. Note that the position technically con
sists of a bearish spread in the calls - buy the higher strike and sell the lower strike -
coupled with a bullish spread in the puts - buy the lower strike and sell the higher
strike. The investment required is in the form of collateral since both spreads are
credit spreads, and is equal to the differential in the striking prices, less the net cred
it received. In this example, then, the investment would be 10 points for the striking
price differential (5 points for the calls and 5 points for the puts) less the 3-point
credit received, for a total collateral requirement of $700, plus commissions.
Chapter 23: Spreads Combining Calls and Puts 351
The potential results from this position may vary widely. However, the risk is
limited before near-tenn expiration. If the underlying stock should advance substan
tially before January expiration, the puts would be nearly worthless and the calls
would both be trading near parity. With the calls at parity, the strategist would have
to pay, at most, 5 points to close the call spread, since the striking prices of the calls
are 5 points apart. In a similar manner, if the underlying stock had declined substan
tially before the near-term January options expired, the calls would be nearly worth
less and the puts would be at parity. Again, it would cost a maximum of 5 points to
close the put spread, since the difference in the striking prices of the puts is also 5
points. The worst result would be a 2-point loss in this example - 3 points of credit
were initially received, and the most that the strategist would have to pay to close the
position is 5 points. This is the theoretical risk. In actual practice, it is very unlikely
that the calls would trade as much as 5 points apart, even if the underlying stock
advanced by a large amount, because the longer-term call should retain some small
time value premium even if it is deeply in-the-money. A similar analysis might apply
to the puts. The risk can always be quickly computed as being equal to the difference
between two contiguous striking prices ( two strikes next to each other), less the net
credit received.
The strategist's objective with this position is to be able to buy back the near
tenn straddle for a price less than the original credit received. If he can do this, he
will own the longer-term combination for free.
Example: Near January expiration, the strategist is able to repurchase the January 40
straddle for 2 points. Since he initially received a 3-point credit and is then able to
buy back the written straddle for 2 points, he is left with an overall credit in the posi
tion of 1 point, less commissions. Once he has done this, the strategist retains the
long options, the April 35 put and April 45 call. If the underlying stock should then
advance substantially or decline substantially, he could make very large profits.
However, even if the long combination expires worthless, the strategist still makes a
profit, since he was able to buy the straddle back for less than the amount of the orig
inal credit.
In this example, the strategist's objective is to buy back the January 40 straddle
for less than 3 points, since that is the amount of the initial credit. At expiration, this
would mean that the stock would have to be between 37 and 43 for the buy-back to
be made for 3 points or less. Although it is possible, certainly, that the stock will be
in this fairly narrow range at near-term expiration, it is not probable. However, the
strategist who is willing to add to his risk slightly can often achieve the same result by
"legging out" of the January 40 straddle. It has repeatedly been stated that one should
352 Part Ill: Put Option Strategies
not attempt to leg out of a spread, but this is an exception to that rule, since one owns
a long combination and therefore is pro


-term expiration, it is not probable. However, the
strategist who is willing to add to his risk slightly can often achieve the same result by
"legging out" of the January 40 straddle. It has repeatedly been stated that one should
352 Part Ill: Put Option Strategies
not attempt to leg out of a spread, but this is an exception to that rule, since one owns
a long combination and therefore is protected; he is not subjecting himself to large
risks by attempting to "leg out" of the straddle he has written.
Example: XYZ rallies before January expiration and the January 40 put drops to a
price of ½ during the rally. Even though there is time remaining until expiration, the
strategist might decide to buy back the put at ½. This could potentially increase his
overall risk by ½ point if the stock continues to rise. However, if the stock then
reversed itself and fell, he could attempt to buy the call back at 2½ points or less. In
this manner, he would still achieve his objective of buying the short-term straddle
back for 3 points or less. In fact, he might be able to close both sides of the straddle
well before near-term expiration if the underlying stock first moves quickly in one
direction and then reverses direction by a large amount.
The maximum risk and the optimum potential objectives have been described,
but interim results might also be considered in this strategy.
Example: XYZ is at 44 at January expiration. The January 40 straddle must be bought
back for 4 points. This means that the long combination will not be owned free, but
will have a cost of I point plus commissions. The strategist must decide at this time
if he wants to hold on to the April options or if he wants to sell them, possibly pro
ducing a small overall profit on the entire position. There is no ironclad rule in this
type of situation. If the decision is made to hold on to the longer-term options, the
strategist realizes that he has assumed additional risk by doing so. Nevertheless, he
may decide that it is worth owning the long combination at a relatively low cost. The
cost in this example would be I point plus commissions, since he paid 4 points to buy
back the straddle after only taking in a 3-point credit initially. The more ex.pensive the
buy-back of the near-term straddle is, the more the strategist should be readily will
ing to sell his long options at the same time. For example, if XYZ were at 48 at
January expiration and the January 40 straddle had to be bought back for 8 points,
there should be no question that he should simultaneously sell his April options as
well. The most difficult decisions come when the stock is just outside the optimum
buy-back area at near-term expiration. In this example, the strategist would have a
fairly difficult decision if XYZ were in the 44 to 45 area or in the 35 to 36 area at
January expiration.
The reader may recall that, in Chapter 14 on diagonalizing a spread, it was men
tioned that one is sometimes able to own a call free by entering into a diagonal cred
it spread. A diagonal bear spread was given as an example. The same thing happens
to be true of a diagonal bullish put spread, since that is a credit spread as well. The
Chapter 23: Spreads Combining Calls and Puts 3S3
strategy discussed in this section is merely a combination of a diagonal bearish call
spread and a diagonal bullish put spread and is known as a "diagonal butterfly
spread." The same concept that was described in Chapter 14 - being able to make
more on the short-term call than one originally paid for the long-term call - applies
here as well. One enters into a credit position with the hope of being able to buy back
the near-term written options for a profit greater than the cost of the long options. If
he is able to do this, he will own options for free and could make large profits if the
underlying stock moves substantially in either direction. Even if the stock does not
move after the buy-back, he still has no risk. The risk occurs prior to the expiration
of the near-term options, but this risk is limited. As a result, this is an attractive strat
egy that, when operated over a period of market cycles, should produce some large
profits. Ideally, these profits would offset any small losses that had to be taken. Since
large commission costs are involved in this strategy, the strategist is reminded that
establishing the spreads in quantity can help to reduce the percentage effect of the
commissions.
SELECTING THE SPREADS
Now that the concepts of these three strategies have been laid out, let us define
selection criteria for them. The "calendar combination" is the easiest of these strate
gies to spot. One would like to have the stock nearly halfway between two striking
prices. The most attractive positions can normally be found when the striking prices
are at least 10 points apart and the underlying stock is relatively volatile. The opti
mum time to establish the "calendar combination" is two or three months before the
near-term options expire. Additionally, one would like the sum of the prices of the
near-term options to be equal to at least one-half of the cost of the longer-term
options. In the example given in the previous section on the "calendar combination,"
the near-term combination was sold for 5 points, and the longer-term combination
was bought for 8 points. Thus, the near-term combination was worth more than one
half of the cost of the longer-term combination. These five criteria can be summa
rized as follows:
1. Relatively volatile stock.
2. Stock price nearly midway between two strikes.
3. Striking prices at least 10 points apart.
4. Two or three months remaining until near-term expiration.
5. Price of near-term combination greater than one-half the price of the longer
term combination.
354 Part Ill: Put Option Strategies
Even though five criteria have been stated, it is relatively easy to find a position that
satisfies all five condi


rice nearly midway between two strikes.
3. Striking prices at least 10 points apart.
4. Two or three months remaining until near-term expiration.
5. Price of near-term combination greater than one-half the price of the longer
term combination.
354 Part Ill: Put Option Strategies
Even though five criteria have been stated, it is relatively easy to find a position that
satisfies all five conditions. The strategist may also be able to rely upon technical
input. If the stock seems to be in a near-term trading range, the position may be more
attractive, for that would indicate that the chances of the near-term combination
expiring worthless are enhanced.
The "calendar straddle" is a strategy that looks deceptively attractive. As the
reader should know by now, options do not decay in a linear fashion. Instead, options
tend to hold time value premium until they get quite close to expiration, when the
time value premium disappears at a fast rate. Consequently, the sale of a near-term
straddle and the simultaneous purchase of a longer-term straddle often appear to be
attractive because the debit seems small. Again, certain criteria can be set forth that
will aid in selecting a reasonably attractive position. The stock should be at or very
near the striking price when the position is established. Since this is basically a neu
tral strategy, one that offers the largest potential profits at near-term expiration, one
should want to sell the most time premium possible. This is why the stock must be
near the striking price initially. The underlying stock does not have to be a volatile
one, although volatile stocks will most easily satisfy the next two criteria. The near
term credit should be at least two-thirds of the longer-term debit. In the example
used to explain this strategy, the near-term straddle was sold for 5, while the longer
term straddle was bought for 7 points. Thus, the near-term straddle was worth more
than two-thirds of the longer-term straddle's price. Finally, the position should be
established with two to four months remaining until near-term expiration. If positions
with a longer time remaining are used, there is a significant probability that the
underlying stock will have moved some distance away from the striking price by the
time the near-term options expire. Summarizing, the three criteria for a "calendar
straddle" are:
1. Stock near striking price initially.
2. Two to four months remaining until near-term expiration.
3. Near-term straddle price at least two-thirds of longer-term straddle price.
The "diagonal butterfly" is the most difficult of these three types of positions to
locate. Again, one would like the stock to be near the middle striking price when the
position is established. Also, one would like the underlying stock to be somewhat
volatile, since there is the possibility that long-term options will be owned for free. If
this comes to pass, the strategist wants the stock to be capable of a large move in
order to have a chance of generating large profits. The most restrictive criterion -:
one that will eliminate all but a few possibilities on a daily basis - is that the near
term straddle price should be at least one and one-half times that of the longer-term,
Chapter 23: Spreads Combining Calls and Puts 355
out-of-the-money combination. By adhering to this criterion, one gives himself area
sonable chance of being able to buy the near-term straddle back for a price low
enough to result in owning the longer-term options for free. In the example used to
describe this strategy, the near-term straddle was sold for 7 while the out-of-the
money, longer-term combination cost 4 points. This satisfies the criterion. Finally,
one should limit his possible risk before near-term expiration. Recall that the risk is
equal to the difference between any two contiguous striking prices, less the net cred
it received. In the example, the risk would be 5 minus 3, or 2 points. The risk should
always be less than the credit taken in. This precludes selling a near-term straddle at
80 for 4 points and buying the put at 60 and the call at 100 for a combined cost of 1
point. Although the credit is substantially more than one and one-half times the cost
of the long combination, the risk would be ridiculously high. The risk, in fact, is 20
points ( the difference between two contiguous striking prices) less the 3 points cred
it, or 17 points - much too high.
The criteria can be summarized as follows:
1. Stock near middle striking price initially.
2. Three to four months to near-term expiration.
3. Price of written straddle at least one and one-half times that of the cost of the
longer-term, out-of-the-money combination.
4. Risk before near-term expiration less than the net credit received.
One way in which the strategist may notice this type of position is when he sees a rel
atively short-term straddle selling at what seems to be an outrageously high price.
Professionals, who often have a good feel for a stock's short-term potential, will some
times bid up straddles when the stock is about to make a volatile move. This will
cause the near-term straddles to be very overpriced. When a straddle seller notices
that a particular straddle looks too attractive as a sale, he should consider establish
ing a diagonal butterfly spread instead. He still sells the overpriced straddle, but also
buys a longer-term, out-of-the-money combination as a hedge against a large loss.
Both factions can be right. Perhaps the stock will experience a very short-term
volatile movement, proving that the professionals were correct. However, this will
not worry the strategist holding a diagonal butterfly, for he has limited risk. Once the
short-term move is over, the stock may drift back toward the original strike, allowing
the near-term straddle to be bought back at a low price - the eventual objective of
the strategist utilizing the diagonal butterfly spread.


atile movement, proving that the professionals were correct. However, this will
not worry the strategist holding a diagonal butterfly, for he has limited risk. Once the
short-term move is over, the stock may drift back toward the original strike, allowing
the near-term straddle to be bought back at a low price - the eventual objective of
the strategist utilizing the diagonal butterfly spread.
These are admittedly three quite complex strategies and thus are not to be
attempted by a novice investor. If one wants to gain experience in how he would
operate such a strategy, it would be far better to operate a "paper strategy" for a
356 Part Ill: Put Option Strategies
while. That is, one would not actually make investments, but would instead follow
prices in the newspaper and make day-to-day decisions without actual risk. This will
allow the inexperienced strategist to gain a feel for how these complex strategies per
form over a particular time period. The astute investor can, of course, obtain price
history information and track a number of market cycles in this same way.
SUMMARY
Puts and call can be combined to make some very attractive positions. The addition
of a call or put credit spread to the outright purchase of a put or call can enhance the
overall profitability of the position, especially if the options are expensive. In addi
tion, three advanced strategies were presented that combined puts and calls at vari
ous expiration dates. These three various types of strategies that involve calendar
combinations of puts and calls may all be attractive. One should be especially alert
for these types of positions when near-term calls are overpriced. Typically, this would
be during, or just after, a bullish period in the stock market. For nomenclature pur
poses, these three strategies are called the "calendar combination," the "calendar
straddle," and the "diagonal butterfly."
All three strategies offer the possibility of large potential profits if the underly
ing stock remains relatively stable until the near-term options expire. In addition, all
three strategies have limited risk, even if the underlying stock should move explo
sively in either direction prior to near-term expiration. If an intermediate result
occurs - for example, the stock moves a moderate distance in either direction before
near-term expiration - it is still possible to realize a limited profit in any of the strate
gies, because of the fact that the time premiums decay much more rapidly in the
near-term options than they do in the longer-term options.
The three strategies have many things in common, but each has its own advan
tages and disadvantages. The "diagonal butterfly" is the only one of the three strate
gies whereby the strategist has a possibility of owning free options. Admittedly, the
probability of actually being able to own the options completely for free is small.
However, there is a relatively large probability that one can substantially reduce the
cost of the long options. The "calendar combination," the first of the three strategies
discussed, offers the largest probability of capturing the entire near-term premium.
This is because both near-term options are out-of-the-money to begin with. The "cal
endar straddle" offers the largest potential profits at near-term expiration. That is, if
the stock is relatively unchanged from the time the position was established until the
time the near-term options expire, the "calendar straddle" will show the best profit
of the three strategies at that time.
Chapter 23: Spreads Combining Calls and l'uts 357
Looking at the negative side, the "calendar straddle" is the least attractive of the
three strategies, primarily because one is forced to increase his risk after near-term
expiration, if he wants to continue to hold the longer-term options. It is often diffi
cult to find a "diagonal butterfly" that offers enough credit to make the position
attractive. Finally, the "calendar combination" has the largest probability oflosing the
entire debit eventually, because one may find that the longer-term options expire
worthless also. (They are out-of-the-money to begin with, just as the near-term
options were.)
The strategist will not normally be able to find a large number of these positions
available at attractive price levels at any particular time in the market. However, since
they are attractive strategies with little or no margin collateral requirements, the
strategist should constantly be looking for these types of positions. A certain amount
of cash or collateral should be reserved for the specific purpose of utilizing it for
these types of positions - perhaps 15 to 20% of one's dollars.
Ratio Spreads Using Puts
The put option spreader may want to sell more puts than he owns. This creates a ratio
spread. Basically, two types of put ratio spreads may prove to be attractive: the stan
dard ratio put spread and the ratio calendar spread using puts. Both strategies are
designed for the more aggressive investor; when operated properly, both can present
attractive reward opportunities.
THE RATIO PUT SPREAD
This strategy is designed for a neutral to slightly bearish outlook on the underlying
stock. In a ratio put spread, one buys a number of puts at a higher strike and sells
more puts at a lower strike. This position involves naked puts, since one is short more
puts than he is long. There is limited upside risk in the position, but the downside risk
can be very large. The maximum profit can be obtained if the stock is exactly at the
striking price of the written puts at expiration.
Example: Given the following:
XYZ common, 50;
XYZ January 45 put, 2; and
XYZ January 50 put, 4.
A ratio put spread might be established by buying one January 50 put and simulta
neously selling two January 45 puts. Since one would be paying $400 for the pur
chased put and would be collecting $400 from the sale of the two out-of-the-money
put


striking price of the written puts at expiration.
Example: Given the following:
XYZ common, 50;
XYZ January 45 put, 2; and
XYZ January 50 put, 4.
A ratio put spread might be established by buying one January 50 put and simulta
neously selling two January 45 puts. Since one would be paying $400 for the pur
chased put and would be collecting $400 from the sale of the two out-of-the-money
puts, the spread could be done for even money. There is no upside risk in this posi
tion. If XYZ should rally and be above 50 at January expiration, all the puts would
358
Cl,apter 24: Ratio Spreads Using Puts 359
expire worthless and the result would be a loss of commissions. However, there is
downside risk. If XYZ should fall by a great deal, one would have to pay much more
to buy back the two short puts than he would receive from selling out the one long
put. The maximum profit would be realized if XYZ were at 45 at expiration, since the
short puts would expire worthless, but the long January 50 put would be worth 5
points and could be sold at that price. Table 24-1 and Figure 24-1 summarize the
position. Note that there is a range within which the position is profitable - 40 to 50
in this example. If XYZ is above 40 and below 50 at January expiration, there will be
some profit, before commissions, from the spread. Below 40 at expiration, losses will
be generated and, although these losses are limited by the fact that a stock cannot
decline in price below zero, these losses could become very large. There is no upside
risk, however, as was pointed out earlier. The following formulae summarize the sit
uation for any put ratio spread:
Maximum upside risk
Maximum profit
potential
= Net debit of spread (no upside risk if done for
a credit)
= Striking price differential x Number of long
puts - Net debit (or plus net credit)
Downside break-even price = Lower strike price - Maximum profit potential +
Number of naked puts
The investment required for the put ratio spread consists of the collateral
requirement necessary for a naked put, plus or minus the credit or debit of the entire
position. Since the collateral requirement for a naked option is 20% of the stock
TABLE 24-1.
Ratio put spread.
XYZ Price at Long January 50 Short 2 January 45 Total
Expiration Put Profit Put Profit Profit
20 +$2,600 -$4,600 -$2,000
30 + 1,600 - 2,600 - 1,000
40 + 600 600 0
42 + 400 200 + 200
45 + 100 + 400 + 500
48 200 + 400 + 200
50 400 + 400 0
60 400 + 400 0
360
FIGURE 24-1.
Ratio put spread.
+$500
C:
0
~ ·5.
X
w
iil
(/) $0 (/)
0 ....I
0
e a.
Part Ill: Put Option Strategies
Stock Price at Expiration
price, plus the premium, minus the amount by which the option is out-of-the-money,
the actual dollar requirement in this example would be $700 (20% of $5,000, plus the
$200 premium, minus the $500 by which the January 45 put is out-of-the-money). As
with all types of naked writing positions, the strategist should allow enough collater
al for an adverse stock move to occur. This will allow enough room for stock move
ment without forcing early liquidation of the position due to a margin call. If, in this
example, the strategist felt that he might stay with the position until the stock
declined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in
the-money amount).
The ratio put spread is generally most attractive when the underlying stock is
initially between the two striking prices. That is, if XYZ were somewhere between 45
and 50, one might find the ratio put spread used in the example attractive. If the
stock is initially below the lower striking price, a ratio put spread is not as attractive,
since the stock is already too close to the downside risk point. Alternatively, if the
stock is too far above the striking price of the written calls, one would normally have
to pay a large debit to establish the position. Although one could eliminate the debit
by writing four or five short options to each put bought, large ratios have extraordi
narily large downside risk and are therefore very aggressive.
Follow-up action is rather simple in the ratio put spread. There is very little that
one need do, except for closing the position if the stock breaks below the downside
break-even point. Since put options tend to lose time value premium rather quickly
after they become in-the-money options, there is not normally an opportunity to roll
Chapter 24: Ratio Spreads Using Puts 361
down. Rather, one should be able to close the position with the puts close to parity if
the stock breaks below the downside break-even point. The spreader may want to buy
in additional long puts, as was described for call spreads in Chapter 11, but this is not
as advantageous in the put spread because of the time value premium shrinkage.
This strategy may prove psychologically pleasing to the less experienced
investor because he will not lose money on an upward move by the underlying stock.
Many of the ratio strategies that involve call options have upside risk, and a large
number of investors do not like to lose money when stocks move up. Thus, although
these investors might be attracted to ratio strategies because of the possibility of col
lecting the profits on the sale of multiple out-of-the-money options, they may often
prefer ratio put spreads to ratio call spreads because of the small upside risk in the
put strategy.
USING DELTAS
The "delta spread" concept can also be used for establishing and adjusting neutral
ratio put spreads. The delta spread was first described in Chapter 11. A neutral put
spread can be constructed by using the deltas of the two put options involved in the
spread. The neutral ratio is determined by dividing the delta of the put at the higher
strike by the delta of the put at the lower strike. Referring to the previous example,
suppose the delta of the January 45 put is -.30 and the delta of the January 50 put is
-.50. Then a


scribed in Chapter 11. A neutral put
spread can be constructed by using the deltas of the two put options involved in the
spread. The neutral ratio is determined by dividing the delta of the put at the higher
strike by the delta of the put at the lower strike. Referring to the previous example,
suppose the delta of the January 45 put is -.30 and the delta of the January 50 put is
-.50. Then a neutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts
would be sold for each put bought. One might thus sell 5 January 45 puts and buy 3
January 50 puts.
This type of spread would not change much in price for small fluctuations in the
underlying stock price. However, as time passes, the preponderance of time value
premium sold via the January 45 puts would begin to tum a profit. As the underlying
stock moves up or down by more than a small distance, the neutral ratio between the
two puts will change. The spreader can adjust his position back into a neutral one by
selling more January 45's or buying more January 50's.
THE RATIO PUT CALENDAR SPREAD
The ratio put calendar spread consists of buying a longer-term put and selling a larg
er quantity of shorter-term puts, all with the same striking price. The position is gen
erally established with out-of-the-money puts that is, the stock is above the striking
price - so that there is a greater probability that the near-term puts will expire worth-
362 Part Ill: Put Option Strategies
less. Also, the position should be established for a credit, such that the money
brought in from the sale of the near-term puts more than covers the cost of the
longer-term put. If this is done and the near-term puts expire worthless, the strate
gist will then own the longer-term put free, and large profits could result if the stock
subsequently experiences a sizable downward movement.
Example: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at
2, one could establish a ratio put calendar spread by buying the April 50 and selling
two January 50 puts. This is a credit position, because the sale of the two January 50
puts would bring in $300 while the cost of the April 50 put is only $200. If the stock
remains above 50 until January expiration, the January 50 puts will expire worthless
and the April 50 put will be owned for free. In fact, even if the April 50 put should
then expire worthless, the strategist will make a small profit on the overall position in
the amount of his original credit - $100 - less commissions. However, after the
Januarys have expired worthless, if XYZ should drop dramatically to 25 or 20, a very
large profit would accrue on the April 50 put that is still owned.
The risk in the position could be very large if the stock should drop well below
50 before the January puts expire. For example, if XYZ fell to 30 prior to January
expiration, one would have to pay $4,000 to buy back the January 50 puts and would
receive only $2,000 from selling out his long April 50 put. This would represent a
rather large loss. Of course, this type of tragedy can be avoided by taking appropri
ate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than
8 to 10% below the striking price before the near-term puts expire.
As with any type of ratio position, naked options are involved. This increases the
collateral requirement for the position and also means that the strategist should allow
enough collateral in order for the follow-up action point to be reached. In this exam
ple, the initial requirement would be $750 (20% of $5,500, plus the $150 January
premium, less the $500 by which the naked January 50 put is out-of-the-money).
However, if the strategist decides that he will hold the position until XYZ falls to 46,
he should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money
amount). Of course, the $100 credit, less commissions, generated by the initial posi
tion can be applied against these collateral requirements.
This strategy is a sensible one for the investor who is willing to accept the risk of
writing a naked put. Since the position should be established with the stock above the
striking price of the put options, there is a reasonable chance that the near-term puts
will expire worthless. This means that some profit will be generated, and that the
profit could be large if the stock should then experience a large downward move
before the longer-term puts expire. One should take care, however, to limit his losses
Chapter 24: Ratio Spreads Using Puts 363
before near-term expiration, since the eventual large profits will be able to overcome
a series of small losses, but could not overcome a preponderance oflarge losses.
RATIO PUt CALENDARS
Using the deltas of the puts in the spread, the strategist can construct a neutral posi
tion. If the puts are initially out-of-the-money, then the neutral spread generally
involves selling more puts than one buys. Another type of ratioed put calendar can
be constructed with in-the-money puts. As with the companion in-the-money spread
with calls, one would buy more puts than he sells in order to create a neutral ratio.
In either case, the delta of the put to be purchased is divided by the delta of the
put to be sold. The result is the neutral ratio, which is used to determine how many
puts to sell for each one purchased.
Example: Consider the out-of-the-money case. XYZ is trading at 59. The January 50
put has a delta of 0.10 and the April 50 put has a delta of -0.17. If a calendar spread
is to be established, one would be buying the April 50 and selling the January 50.
Thus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts
would be sold for every 10 purchased.
This spread has naked puts and therefore has large risk if the underlying stock
declines too far. However, follow-up action could be taken if the stock dropped in an
orderly manner. Such action would be des


ed, one would be buying the April 50 and selling the January 50.
Thus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts
would be sold for every 10 purchased.
This spread has naked puts and therefore has large risk if the underlying stock
declines too far. However, follow-up action could be taken if the stock dropped in an
orderly manner. Such action would be designed to limit the downside risk.
Conversely, the calendar spread using in-the-money puts would normally have
one buying more options than he is selling. An example using deltas will demonstrate
this fact:
Example: XYZ is at 59. The January 60 put has a delta of -0.45 and the April 60 put
has a delta of -0.40. It is normal for shorter-term, in-the-money options to have a
delta that is larger (in absolute terms) than longer-term, in-the-money options.
The neutral ratio for this spread would be 0.889 (-0.40/-0.45). That is, one
would sell only 0.889 puts for each one he bought. Alternatively stated, he would sell
8 and buy 9.
A spread of this type has no naked puts and therefore does have large downside
profit potential. If the stock should rise too far, the loss is limited to the initial debit
of the spread. The optimum result would occur if the stock were at the strike at expi
ration because, even though the excess long put would lose money in that case, the
spreads involving the other puts would overcome that small loss.
Another risk of the in-the-money put spread is that one might be assigned
rather quickly if the stock should drop. In fact, one must be careful not to establish
364 Part Ill: Put Option Strategies
the spread with puts that are too deeply in-the-money, for this reason. While being
put will not necessarily change the profitability of the spread, it will mean increased
commission costs and margin charges for the customer, who must buy the stock upon
assignment.
A LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION)
The previous section demonstrated that ratio put calendar spreads can be attractive.
The ratio call calendar spread was described earlier as a reasonably attractive strate
gy for the bullish investor. A logical combination of these two types of ratio calendar
spreads (put and call) would be the ratio combination - buying a longer-term out-of
the-money combination and selling several near-term out-of-the-money combina
tions.
Example: The following prices exist:
XYZ common: 55
XYZ January 50 put:
XYZ January 60 call:
XYZ April 50 put: 2
XYZ April 60 call: 5
One could sell the near-term January combination (January 50 put and January 60
call) for 5 points. It would cost 7 points to buy the longer-term April combination
(April 50 put and April 60 call). By selling more January combinations than April com
binations bought, a ratio calendar combination could be established. For example,
suppose that a strategist sold two of the near-term January combinations, bringing in
10 points, and simultaneously bought one April combination for 7 points. This would
be a credit position, a credit of 3 points in this example. If the near-term, out-of-the
money combination expires worthless, a guaranteed profit of 3 points will exist, even
if the longer-term options proceed to expire totally worthless. If the near-term com
bination expires worthless, the longer-term combination is owned for free, and a large
profit could result on a substantial stock price movement in either direction.
Although this is a superbly attractive strategy if the near-term options do, in
fact, expire worthless, it must also be monitored closely so that large losses do not
occur. These large losses would be possible if the stock broke out in either direction
too quickly, before the near-term options expire. In the absence of a technical opin
ion on the underlying stock, one can generally compute a stock price at which it
might be reasonable to take follow-up action. This is a similar analysis to the one
Chapter 24: Ratio Spreads Using Puts 365
described for ratio call calendar spreads in Chapter 12. Suppose the stock in this
example began to rally. There would be a point at which the strategist would have to
pay 3 points of debit to close the call side of the combination. That would be his
break-even point.
Example: With XYZ at 65 at January expiration (5 points above the higher strike of
the original combination), the near-term January 60 call would be worth 5 points and
the longer-term April 60 call might be worth 7 points. If one closed the call side of
the combination, he would have to pay 10 points to buy back two January 60 calls,
and would receive 7 points from selling out his April 60. This closing transaction
would be a 3-point debit. This represents a break-even situation up to this point in
time, except for commissions, since a 3-point credit was initially taken in. The strate
gist would continue to hold the April 50 put (the January 50 put would expire worth
less) just in case the improbable occurs and the underlying stock plunges below 50
before April expiration. A similar analysis could be performed for the put side of the
spread in case of an early downside breakout by the underlying stock. It might be
determined that the downside break-even point at January expiration is 46, for exam
ple. Thus, the strategist has two parameters to work with in attempting to limit loss
es in case the stock moves by a great deal before near-term expiration: 65 on the
upside and 46 on the downside. In practice, if the stock should reach these levels
before, rather than at, January expiration, the strategist would incur a small loss by
closing the in-the-money side of the combination. This action should still be taken,
however, as the objective of risk management of this strategy is to take small losses, if
necessary. Eventually, large profits may be generated that could more than compen
sate for any small losses that were incurred.
The foregoing follow-up ac


at, January expiration, the strategist would incur a small loss by
closing the in-the-money side of the combination. This action should still be taken,
however, as the objective of risk management of this strategy is to take small losses, if
necessary. Eventually, large profits may be generated that could more than compen
sate for any small losses that were incurred.
The foregoing follow-up action was designed to handle a volatile move by the
underlying stock prior to near-term expiration. Another, perhaps more common, time
when follow-up action is necessary is when the underlying stock is relatively
unchanged at near-term expiration. If XYZ in the example above were near 55 at
January expiration, a relatively large profit would exist at that time: The near-term
combination would expire worthless for a gain of 10 points on that sale, and the
longer-term combination would probably still be worth about 5 points, so that the
unrealized loss on the April combination would be only 2 points. This represents a
total (realized and unrealized) gain of 8 points. In fact, as long as the near-term com
bination can be bought back for less than the original 3-point credit of the position,
the position will show a total unrealized gain at near-term expiration. Should the gain
be taken, or should the longer-term combination be held in hopes of a volatile move
by the underlying stock? Although the strategist will normally handle each position
366 Part Ill: Put Option Strategies
on a case-by-case basis, the general philosophy should be to hold on to the April com
bination. A profit is already guaranteed at this time - the worst that can happen is a
3-point profit (the original credit). Consequently, the strategist should allow himself
the opportunity to make large profits. The strategist may want to attempt to trade out
of his long combination, since he will not risk making the position a losing one by
doing so. Technical analysis may be able to provide him with buy or sell zones on the
stock, and he would then consider selling out his long options in accordance with
these technical levels.
In summary, this strategy is very attractive and should be utilized by strategists
who have the expertise to trade in positions with naked options. As long as risk man
agement principles of taking small losses are adhered to, there will be a large proba
bility of overall profit from this strategy.
PUT OPTION SUMMARY
This concludes the section on put option strategies. The put option is useful in a vari
ety of situations. First, it represents a more attractive way to take advantage of a bear
ish attitude with options. Second, the use of the put options opens up a new set of
strategies - straddles and combinations - that can present reasonably high levels of
profit potential. Many of the strategies that were described in Part II for call options
have been discussed again in this part. Some of these strategies were described more
fully in terms of philosophy, selection procedures, and follow-up action when they
were first discussed. The second description the one involving put options - was
often shortened to a more mechanical description of how puts fit into the strategy.
This format is intentional. The reader who is planning to employ a certain strategy
that can be established with either puts or calls (a bear spread, for example) should
familiarize himself with both applications by a simultaneous review of the call chap
ter and its analogous put chapter.
The combination strategies generally introduced new concepts to the reader.
The combination allows the construction of positions that are attractive with either
puts or calls (out-of-the-money calendar spreads, for example) to be combined into
one position. The four combination strategies that involve selling short-term options
and simultaneously buying longer-term options are complex, but are most attractive
in that they have the desirable features of limited risk and large potential profits.
CHAPTER 25
LEAPS
In an attempt to provide customers with a broader range of derivative products, the
options exchanges introduced LEAPS. This chapter does a fair amount of reviewing
basic option facts in order to explain the concepts behind LEAPS. The reader who
has a knowledge of the preceding chapters and therefore does not need the review
will be able to quickly skim through this chapter and pick out the strategically impor
tant points. However, if one encounters concepts here that don't seem familiar, he
should review the earlier chapter that discusses the pertinent strategy.
The term LEAPS is a name for "long-term option." A LEAPS is nothing more
than a listed call or put option that is issued with two or more years of time remain
ing. It is a longer-term option than we are used to dealing with. Other than that, there
is no material difference between LEAPS and the other calls and puts that have been
discussed in the previous chapters.
LEAPS options were first introduced by the CBOE in October 1990, and were
offered on a handful of blue-chip stocks. Their attractiveness spurred listings on
many underlying stocks on all option exchanges as well as on several indices. (Index
options are covered in a later section of the book.)
Strategies involving long-term options are not substantially different from those
involving shorter-term options. However, the fact that the option has so much time
remaining seems to favor the buyer and be a detriment to the seller. This is one rea
son why LEAPS have been popular. As a strategist, one knows that the length of time
remaining has little to do with whether a certain strategy makes sense or not. Rather,
it is the relative value of the option that dictates strategy. If an option is overpriced,
it is a viable candidate for selling, whether it has two years of life remaining or two
months. Obviously, follow-up action may become much more of a necessity during
the life of a two-y


knows that the length of time
remaining has little to do with whether a certain strategy makes sense or not. Rather,
it is the relative value of the option that dictates strategy. If an option is overpriced,
it is a viable candidate for selling, whether it has two years of life remaining or two
months. Obviously, follow-up action may become much more of a necessity during
the life of a two-year option; that matter is discussed later in this chapter.
361
368 Part Ill: Put Option Strategies
THE BASICS
Certain facets of LEAPS are the same as for other listed equity options, while others
involve slight differences. The amount of standardization is considerably less, which
makes the simple process of quoting LEAPS a bit more tedious. LEAPS are listed
options that can be traded in a secondary market or can be exercised before expira
tion. As with other listed equity options, they do not receive the dividend paid by the
underlying common stock.
Recall that four specifications uniquely describe any option contract:
1. the type (put or call),
2. the underlying stock name (and symbol),
3. the expiration date, and
4. the striking price.
Type. LEAPS are puts or calls. The LEAPS owner has the right to buy the stock at
the striking price (LEAPS call) or sell it there (LEAPS put). This is exactly the same
for LEAPS and for regular equity options.
Underlying Stock and Quote Symbol. The underlying stocks are the
same for LEAPS as they are for equity options. The base symbol in an option quote
is the part that designates the underlying stock. For equity options, the base symbol
is the same as the stock symbol. However, until the Option Price Reporting Authority
( OPRA) changes the way that all options are quoted, the base symbols for LEAPS are
not the same as the stock symbols. For example, LEAPS options on stock XYZ might
trade under the base symbol WXY; so it is possible that one stock might have listed
options trading with different base symbols even though all the symbols refer to the
same underlying stock. Check with your broker to determine the LEAPS symbol if
you need to know it.
Expiration Date. LEAPS expire on the Saturday following the third Friday of
the expiration month, just as equity options do. One must look in the newspaper, ask
his broker, or check the Internet (www.cboe.com) to determine what the expiration
months are, however, since they are also not completely standardized. When LEAPS
were first listed, there were differing expiration months through December 1993. At
the current time, LEAPS are issued to expire in January of each year, so some
attempt is being made at standardization. However, there is no guarantee that vary
ing expiration months won't reappear at some future time.
Chapter 25: LEAPS 369
Striking Price. There is no standardized striking price interval for LEAPS as
there is for equity options. If XYZ is a 95-dollar stock, there might be LEAPS with
striking prices of 80, 95, and 105. Again, one must look in the newspaper, ask his bro
ker, or check the Internet (www.cboe.com) to determine the actual LEAPS striking
prices for any specific underlying stock. New striking prices can be introduced when
the underlying stock rises or falls too far. For example, if the lowest strike for XYZ
were 80 and the stock fell to 80, a new LEAPS strike of 70 might be introduced.
Other Basic Factors. LEAPS may be exercised at any time during their life,
just as is the case with equity options. Note that this statement regarding exercise is
not necessarily true for Index LEAPS or Index Options. See Part V of this book for
discussions of index products.
Standard LEAPS contracts are for 100 shares of the underlying stock, just as
equity options are. The number of shares would be adjusted for stock splits and stock
dividends (leading to even more arcane LEAPS symbol problems). LEAPS are quot
ed on a per-share basis, as are other listed options.
There are position and exercise limits for LEAPS just as there are for other list
ed options. One must add his LEAPS position and his regular equity option position
together in order to determine his entire position quantity. Exemptions may be
obtained for bona fide hedgers of common stock.
As time passes, LEAPS eventually have less than 9 months remaining until expi
ration. When such a time is reached, the LEAPS are "renamed" and become ordi
nary equity options on the underlying security.
Example: Assume LEAPS on stock XYZ were initially issued to expire two years
hence. Assume that one of these LEAPS is the XYZ January 90; that is, it has a strik
ing price of 90 and expires in January, two years from now. Its symbol is WXYAR
(WXY being the LEAPS base symbol assigned by the exchange where XYZ is traded,
A for January, and R for 90).
Fifteen months later, the January LEAPS only have 9 months of life remaining.
The LEAPS symbol would be changed from WXYAR to XYZAR (a regular equity
option), and the quotes would be listed in the regular equity option section of the
newspaper instead of in the LEAPS section.
PRICING LEAPS
Terms such as in-the-money, out-of-the-money, intrinsic value, time value premium,
and parity all apply and have the same definitions. The factors influencing the prices
of LEAPS are the same as those for any other option:
370 Part Ill: Put Option Strategies
1. underlying stock price,
2. striking price,
3. time remaining,
4. volatility,
5. risk-free interest rate, and
6. dividend rate.
The relative influence of these factors may be a little more pronounced for
LEAPS than it is for shorter-term equity options. Consequently, the trader may think
that a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One
should be careful in his evaluation of LEAPS until he has acquired experience in
observing how their prices relate to the shorter-tenn equity options with which he is
experienced.
It might prove useful to reexamine the option pricing


it is for shorter-term equity options. Consequently, the trader may think
that a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One
should be careful in his evaluation of LEAPS until he has acquired experience in
observing how their prices relate to the shorter-tenn equity options with which he is
experienced.
It might prove useful to reexamine the option pricing curve with some LEAPS
included. Please refer to Figure 25-1 for the pricing curves of several options. As
always, the solid intrinsic value line is the bottom line; it is the same for any call
option. The curves are all drawn with the same values for the pertinent variables:
stock price, striking price, volatility, short-term interest rate, and dividends. Thus,
they can be compared directly.
The most obvious thing to notice about the curves in Figure 25-1 is that the
curve depicting the 2-year LEAPS is quite flat. It has the general shape of the
shorter-term curves, but there is so much time value at stock prices even 25% in
or out-of-the-money, that the 2-year curve is much flatter than the others.
Other observations can be made as well. Notice the at-the-money options: The
2-year LEAPS sells for a little more than four times the 3-month option. As we shall
see, this can change with the effects of interest rates and dividends, but it confirms
something that was demonstrated earlier: Time decay is not linear. Thus, the 2-year
LEAPS, which has eight times the amount of time remaining as compared to the 3-
month call, only sells for about four times as much. This LEAPS might appear cheap
to the casual observer, but remember that these graphs depict the fair values for this
set of input parameters. Do not be deluded into thinking that a LEAPS looks cheap
merely by comparing its price to a nearer-term option; use a model to evaluate it, or
at least use the output of someone else's model.
The curves in Figure 25-1 depict the relationships between stock price, striking
price, and time remaining. The most important remaining determinant of an option's
price is the volatility of the underlying stock. Changes in volatility can greatly change
the price of any option. This is especially true for LEAPS, since a long-term option's
price will fluctuate greatly when volatility changes only a little. Some observations on
the differing effects that volatility changes have on short- and long-term options are
presented later.
Chapter 25: LEAPS
FIGURE 25-1.
LEAPS call pricing curve.
45
40
35
Q) 30 .g
o. 25
'lii U 20
15
10
5
, .... ,,
Various Expiration Dates
Strike= 80
2 Years (LEAP) , '
' ,,,,'
,, ,,
,, ,, ,,
"' ,, ,, ,, ,,
,,' ,,
,. ,, ,,
0 L----~==--..l.---..J£----1.---L----.I....--
60 70 80 90 100 110
Stock Price
371
Before that discussion, however, it may be beneficial to examine the effects that
interest rates and dividends can have on LEAPS. These effects are much, much
greater than those on conventional equity options. Recall that it was stated that inter
est rates and dividends are minor determinants in the price of an option, unless the
dividends were large. That statement pertains mostly to short-term options. For
longer-term options such as LEAPS, the cumulative effect of an interest rate or div
idend over such a long period of time can have a magnified effect in terms of the
absolute price of the option.
Figure 25-2 presents the option pricing curve again, but the only option depict
ed is a 2-year LEAPS. The striking price is 100, and the straight line at the right
depicts the intrinsic value of the LEAPS. The three curves represent option prices
for risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration,
volatility, and dividends) are fixed. The difference between option prices caused
merely by a shift in rates of 3% is very large.
The difference in LEAPS prices increases as the LEAPS becomes in-the
money. Note that in this figure, the distance between the curves gets wider as one
scans them from left to right. The price difference for out-of-the-money LEAPS is
large enough- nearly a point even for options fairly far out-of-the-money (that is, the
points on the left-hand side of the graph). A shift of 3% in rates causes a larger price
difference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen
tial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but
when LEAPS strategies are examined later, the reasons for this will become clear.
372 Part Ill: Put Option Strategies
Suffice it to say that the in-the-money LEAPS are changed in price by over 4 points
when rates change by 3%. That is a monstrous differential and should cause any trad
er who is considering trading in-the-money LEAPS to consider what his outlook is
for short-term interest rates.
There is always a substantial probability that rates can change by 3% in two
years. Thus, it is difficult to predict with any certainty what risk-free rate to use in the
pricing of two-year LEAPS. Moreover, one should be very careful when deciding
LEAPS are "cheap" or "expensive" because, conventionally, the short-term interest
rate is not usually considered as a significant factor in making such an analysis. For
LEAPS, however, Figure 25-2 is obvious proof that interest rate considerations are
important for LEAPS traders.
Now consider dividends. Figure 25-3 depicts the prices of two-year LEAPS
calls. The three curves on the graph are for different dividend rates - the top line
representing the current rate, the middle line representing prices if the dividend
were raised by $1 annually, and the bottom line showing what prices would be if
the dividend were raised by $2 annually. All other factors (volatility, time remain
ing, and risk-free interest rates) are the same for each curve in this graph. The
increase in dividends manifests itself by decreasing the LEAPS call price. The rea
son that this is true, of


line representing prices if the dividend
were raised by $1 annually, and the bottom line showing what prices would be if
the dividend were raised by $2 annually. All other factors (volatility, time remain
ing, and risk-free interest rates) are the same for each curve in this graph. The
increase in dividends manifests itself by decreasing the LEAPS call price. The rea
son that this is true, of course, is that the stock will be reduced in price more when
it goes ex-dividend by the larger amounts of the increased dividends.
FIGURE 25-2.
2-year LEAPS call pricing curve, interest rate comparison.
35
30
25
Q)
(.)
~ 20
C:
0
a 15 0
10
5
Stock Price
Chapter 25: LEAPS
FIGURE 25-3.
LEAPS call pricing curve as dividends increase.
30
25
(I)
.g 20
0..
C:
:g_ 15
0
10
5
0
70 80 90 100
Stock Price
With
Current
Dividend
110
373
Dividend
)> Increases
$1
T Increases
$2
120
The actual amount that the LEAPS calls lose in price increases slightly as the
call is more in-the-money. That is, the curves are closer together on the left-hand
(out-of-the-money) side than they are on the right-hand (in-the-money) side. For the
in-the-money call, a $1 increase in dividends over two years can cause the LEAPS to
be worth about 1 ½ points less in value.
Figure 25-3 is to the same scale as Figure 25-2, so they can be compared direct
ly in terms of magnitude. Notice that the effect of a $1 increase in dividends on the
LEAPS call prices is much smaller than that of an increase in interest rates by 3%.
Graphically speaking, one can observe this by noting that the spaces between the
three curves in the previous figure are much wider than the spaces between the three
curves in this figure.
Finally, note that dividend increases have the opposite effect on puts. That is,
an increase in the dividend payout of the underlying common will cause a put to
increase in price. If the put is a long-term LEAPS put, then the effect of the increase
will be even larger.
Lest one think that LEAPS are too difficult to price objectively, note the follow
ing. The prior figures of interest rate and dividend effects tend to magnify the effects
on LEAPS prices for two reasons. First, they depict the effects on 2-year LEAPS. That
is a large amount of life for LEAPS. Many LEAPS have less life remaining, so the
effects would be diminished somewhat for LEAPS with 10 to 23 months of life left.
374 Part Ill: Put Option Strategies
Second, the figures depict the change in rates or dividends as being instantaneous.
This is not completely realistic. If rates change, they will change by a little bit at a time,
usually¼% or½% at a time, perhaps as much as 1 %. If dividends are increased, that
increase may be instantaneous, but it will not likely occur immediately after the
LEAPS are purchased or sold. However, the point that these figures are meant to con
vey is that interest rates and dividends have a much greater effect on LEAPS than on
ordinary shorter-term equity options, and that is certainly a true statement.
COMPARING LEAPS AND SHORT-TERM OPTIONS
Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or
with a model. All of the variables - stock price, volatility, interest rates, and dividends
- are given in increments and the comparison is shown between 3-month equity
options and 2-year LEAPS. There are three sets of comparisons: for options 20% out
of-the-money, options at-the-money, and options 20% in-the-money.
A few words are needed here to explain how volatility is shown in this table.
Volatility is normally expressed as a percent. The volatility of the stock market is
about 15%. The table shows what would happen if volatility changed by one per
centage point, to 16%, for example. Of course, the table also shows what would hap
pen if the other factors changed by a small amount.
Most of the discrepancies between the 3-month and the 2-year options are
large. For example, if volatility increases by one percentage point, the 3-month out
of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column)
while the 2-year LEAPS call will increase by 43 cents. As another example, look at
the bottom right-hand pair of numbers, which show the effect of a dividend increase
on the options that are 20% in-the-money. The assumption is that the dividend will
increase 25 cents this quarter (and will be 25 cents higher every quarter thereafter).
This translates into a loss of 14 cents for the 3-month call, since there is only one ex
dividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year
LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call.
TABLE 25-1.
Comparing LEAPS and Short-Term Calls.
Change in Price of the Options
20% out at 20% in
Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr .
Stock Pre. + 1 pt . 03 .41 .54 .70 .97 .89
Volatility + 1% .03 .43 .21 .48 .04 .33
Int. Rate + 1/2% .01 .27 .08 .55 .14 .72
Dividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50
Chapter 25: LEAPS 375
The table also shows that only three of the discrepancies are not large. Two
involve the stock price change. If the stock changes in price by 1 point, neither the at
the-money nor the in-the-money options behave very differently, although the at-the
money LEAPS do jump by 70 cents. The observant reader will notice that the top line
of the table depicts the delta of the options in question; it shows the change in option
price for a one-point change in stock price. The only other comparison that is not
extremely divergent is that of volatility change for the at-the-money option. The 3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still a factor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignor


arison that is not
extremely divergent is that of volatility change for the at-the-money option. The 3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still a factor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignore the effect of a rise in interest rates of ½
of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by
a mere 1 %, or maybe even of the stock moving by one point (only if his option is out
of-the-money). The LEAPS option trader will gain or suffer substantially and imme
diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½
point of value - a significant amount, to be sure.
LEAPS STRATEGIES
Many of the strategies involving LEAPS are not significantly different from their
counterparts that involve short-term options. However, as shown earlier, the long
term nature of the LEAPS can sometimes cause the strategist to experience a result
different from that to which he has become accustomed.
As a general rule, one would want to be a buyer of LEAPS when interest rates
were low and when the volatilities being implied in the marketplace are low. If the
opposite were true (high rates and high volatilities), he would lean toward strategies
in which the sale of LEAPS is used. Of course, there are many other specific consid
erations when it comes to operating a strategy, but since the long-term nature of
LEAPS exposes one to interest rate and volatility movements for such a long time,
one may as well attempt to position himself favorably with respect to those two ele
ments when he enters a position.
LEAPS AS STOCK SUBSTITUTE
Any in-the-money option can be used as a substitute for the underlying stock. Stock
owners may be able to substitute a long in-the-money call for their long stock. Short
sellers of stock may be able to substitute a long put for their short stock. This is not
a new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls.
It has been available as a strategy for some time with short-term options. Its attrac
tiveness seems to have increased somewhat with the introduction of LEAPS, howev-
374 Part Ill: Put Option Strategies
Second, the figures depict the change in rates or dividends as being instantaneous.
This is not completely realistic. If rates change, they will change by a little bit at a time,
usually¼% or ½% at a time, perhaps as much as 1 %. If dividends are increased, that
increase may be instantaneous, but it will not likely occur immediately after the
LEAPS are purchased or sold. However, the point that these figures are meant to con
vey is that interest rates and dividends have a much greater effect on LEAPS than on
ordinary shorter-term equity options, and that is certainly a true statement.
COMPARING LEAPS AND SHORT-TERM OPTIONS
Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or
with a model. All of the variables - stock price, volatility, interest rates, and dividends
- are given in increments and the comparison is shown between 3-month equity
options and 2-year LEAPS. There are three sets of comparisons: for options 20% out
of-the-money, options at-the-money, and options 20% in-the-money.
A few words are needed here to explain how volatility is shown in this table.
Volatility is normally expressed as a percent. The volatility of the stock market is
about 15%. The table shows what would happen if volatility changed by one per
centage point, to 16%, for example. Of course, the table also shows what would hap
pen if the other factors changed by a small amount.
Most of the discrepancies between the 3-month and the 2-year options are
large. For example, if volatility increases by one percentage point, the 3-month out
of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column)
while the 2-year LEAPS call will increase by 43 cents. As another example, look at
the bottom right-hand pair of numbers, which show the effect of a dividend increase
on the options that are 20% in-the-money. The assumption is that the dividend will
increase 25 cents this quarter ( and will be 25 cents higher every quarter thereafter).
This translates into a loss of 14 cents for the 3-month call, since there is only one ex
dividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year
LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call.
TABLE 25-1.
Comparing LEAPS and Short-Term Calls.
Change in Price of the Options
20% out al 20% in
Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr.
Stock Pre. + 1 pt .03 .41 .54 .70 .97 .89
Volatility + 1% .03 .43 .21 .48 .04 .33
Int. Rate + 1/2% .01 .27 .08 .55 .14 .72
Dividend + $.25/qtr 0 -.62 -.08 - l.18 -.14 -1.50
Chapter 25: LEAPS 375
The table also shows that only three of the discrepancies are not large. Two
involve the stock price change. If the stock changes in price by 1 point, neither the at
the-money nor the in-the-money options behave very differently, although the at-the
money LEAPS do jump by 70 cents. The observant reader will notice that the top line
of the table depicts the delta of the options in question; it shows the change in option
price for a one-point change in stock price. The only other comparison that is not
extremely divergent is that of volatility change for the at-the-money option. The 3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still a factor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignore the effect of a rise in interest rates of½
of 1 %, of a 25-cent increase in the quarterly dividend


3-
month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is
still a factor of two-to-one, but is much less than the other comparisons in the table.
Study the other comparisons in the table. The trader who is used to dealing with
short-term options might ordinarily ignore the effect of a rise in interest rates of½
of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by
a mere 1 %; or maybe even of the stock moving by one point (only if his option is out
of-the-money). The LEAPS option trader will gain or suffer substantially and imme
diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½
point of value - a significant amount, to be sure.
LEAPS STRATEGIES
Many of the strategies involving LEAPS are not significantly different from their
counterparts that involve short-term options. However, as shown earlier, the long
term nature of the LEAPS can sometimes cause the strategist to experience a result
different from that to which he has become accustomed.
As a general rule, one would want to be a buyer of LEAPS when interest rates
were low and when the volatilities being implied in the marketplace are low. If the
opposite were true (high rates and high volatilities), he would lean toward strategies
in which the sale of LEAPS is used. Of course, there are many other specific consid
erations when it comes to operating a strategy, but since the long-term nature of
LEAPS exposes one to interest rate and volatility movements for such a long time,
one may as well attempt to position himself favorably with respect to those two ele
ments when he enters a position.
LEAPS AS STOCK SUBSTITUTE
Any in-the-money option can be used as a substitute for the underlying stock. Stock
owners may be able to substitute a long in-the-money call for their long stock. Short
sellers of stock may be able to substitute a long put for their short stock. This is not
a new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls.
It has been available as a strategy for some time with short-term options. Its attrac
tiveness seems to have increased somewhat with the introduction of LEAPS, howev-
376 Part Ill: Put Option Strategies
er. More and more people are examining the potential of selling the stock they own
and buying long-term calls (LEAPS) as a substitute, or buying LEAPS instead of
making an initial purchase in a particular common stock.
Substitution for Stock Currently Held Long. Simplistically, this strate
gy involves this line of thinking: If one owns stock and sells it, an investor could rein
vest a small portion of the proceeds in a call option, thereby providing continued
upside profit potential if the stock rises in price, and invest the rest in a bank to earn
interest. The interest earned would act as a substitute for the dividend, if any, to
which the investor is no longer entitled. Moreover, he has less downside risk: If the
stock should fall dramatically, his loss is limited to the initial cost of the call.
In actual practice, one should carefully calculate what he is getting and what he
is giving up. For example, is the loss of the dividend too great to be compensated for
by the investment of the excess proceeds? How much of the potential gain will be
wasted in the form of time value premium paid for the call? The costs to the stock
owner who decides to switch into call options as a substitute are commissions, the
time value premium of the call, and the loss of dividends. The benefits are the inter
est that can be earned from freeing up a substantial portion of his funds, plus the fact
that there is less downside risk in owning the call than in owning the stock.
Example: XYZ is selling at 50. There are one-year LEAPS with a striking price of 40
that sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates
are 5%. What are the economics that an owner of 100 XYZ common stock must cal
culate in order to determine whether it is viable to sell his stock and buy the one-year
LEAPS as a substitute?
The call has time value premium of 2 points (40 + 12 - 50). Moreover, if the
stock is sold and the LEAPS purchased, a credit of $3,800 less commissions would
be generated. First, calculate the net credit generated:
Credit balance generated:
Sale of 1 00 XYZ stock
Less stock commission
Net sale proceeds:
Cost of one LEAPS call
Plus option commission
Net cost of call:
Total credit balance:
$5,000
25
$4,975 credit
$3,760 credit
$1,200
15
$1,215 debit
Now the costs and benefits of making the switch can be computed:
Chapter 25: LEAPS
Costs of switching:
Time value premium
Loss of dividend
Stock commissions
Option commissions
Total cost:
Fixed benefit from switching:
Interest earned on
credit balance of $3,760
at 5% interest for one year= 0.05 x $3,760:
Net cost of switching:
317
-$200
-$ 50
-$ 25
- .l__Ll_
-$290
+ $188
- $102
The stock owner must now decide if it is worth just over $1 per share in order
to have his downside risk limited to a price of 39½ over the next year. The price of
39½ as his downside risk is merely the amount of the net credit he received from
doing the switch ($3,760) plus the interest earned ($188), expressed in per-share
terms. That is, if XYZ falls dramatically over the next year and the LEAPS expires
worthless, this investor will still have $3,948 in a bank account. That is equivalent to
limiting his risk to about 39½ on the original 100 shares.
If the investor decides to make the substitution, he should invest the proceeds
from the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the
current rate - the one used in his calculations - for the year. Second, he is not tempt
ed to use the money for something else, an action that might negate the potential
benefits of the substitution.
The above calculations all assume that the LEAPS call or the stock


bstitution, he should invest the proceeds
from the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the
current rate - the one used in his calculations - for the year. Second, he is not tempt
ed to use the money for something else, an action that might negate the potential
benefits of the substitution.
The above calculations all assume that the LEAPS call or the stock would have
been held for the full year. If that is known not to be the case, the appropriate costs
or benefits must be recalculated.
Caveats. This ($102) seems like a reasonably small price to pay to make the switch
from common stock to call ownership. However, if the investor were planning to sell
the stock before it fell to 39½ in any case, he might not feel the need to pay for this
protection. (Be aware, however, that he could accomplish essentially the same thing,
since he can sell his LEAPS call whenever he wants to.) Moreover, when the year is
up, he will have to pay another stock commission to repurchase his XYZ common if
he still wants to own it ( or he will have to pay two option commissions to roll his long
call out to a later expiration date). One other detriment that might exist, although a
relatively unlikely one, is that the underlying common might declare an increased
dividend or, even worse, a special cash dividend. The LEAPS call owner would not
be entitled to that dividend increase in whatever form, while, obviously, the common
378 Part Ill: Put Option Strategies
stock owner would have been. If the company declared a stock dividend, it would
have no effect on this strategy since the call owner is entitled to those. A change in
interest rates is not a factor either, since the owner of the LEAPS should invest in a
1-year Treasury bill or a 1-year CD and therefore would not be subject to interim
changes in short-term interest rates.
There may be other mitigating circumstances. Mostly these would involve tax
considerations. If the stock is currently a profitable investment, the sale would gen
erate a capital gain, and taxes might be owed. If the stock is currently being held at
a loss, the purchase of the call would constitute a wash sale and the loss could not be
taken at this time. (See Chapter 41 on taxes for a broader discussion of the wash sale
rule and option trading.)
In tl1eory, the calculations above could produce an overall credit, in which case the
stockholder W(?uld normally want to substitute with the call, unless he has overriding tax
considerations or suspects that a cash dividend increase is going to be announced. Be
very careful about switching if this situation should arise. Normally, arbitrageurs - per
sons trading for exchange members and paying no commission - would take advantage
of such a situation before the general public could. If they are letting the opportunity
pass by, there must be a reason (probably the cash dividend), so be extremely certain of
your economics and research before venturing into such a situation.
In summary, holders of common stock on which there exist in-the-money
LEAPS should evaluate the economics of substituting the LEAPS call for the com
mon stock. Even if arithmetic calculations call for the substitution, the stockholder
should consider his tax situation as well as his outlook for the cash dividends to be
paid by the common before making the switch.
BUYING LEAPS AS THE INITIAL PURCHASE
INSTEAD OF BUYING A COMMON STOCK
Logic similar to that used earlier to determine whether a stockholder might want to
substitute a LEAPS call for his stock can be used by a prospective purchaser of com
mon stock. In other words, this investor does not already own the common. He is
going to buy it. This prospective purchaser might want to buy a LEAPS call and put
the rest of the money he had planned to use in the bank, instead of actually buying
the stock itself.
His costs - real and opportunity - are calculated in a similar manner to those
expressed earlier. The only real difference is that he has to spend the stock commis
sion in this case, whereas he did not in the previous example (since he already owned
the stock).
Chapter 25: LEAPS 379
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%.
The initial purchaser of common stock would have certain "opportunity" costs
and savings if he decided instead to buy the LEAPS calls. First, calculate the differ
ence in investment required for the stock versus the LEAPS:
Costs:
Prospective initial investment:
Stock: $5,000 + $25 commission
LEAPS: $1,200 + $15 commission
Net difference:
Now calculate the costs versus the savings:
Time value premium
Loss of dividend
Savings:
Interest on $3, 810 for one year at 5%:
Net opportunity cost:
$5,025
$1,215
$3,810
-$200
-$ 50
+$190
-$ 60
In this case, it seems even more likely that the prospective stock purchaser
would instead buy the LEAPS call. His net "cost" of doing so, provided he puts the
difference in initial investment in a 1-year CD or Treasury bill, is only $60. For this
small amount, he has all the upside appreciation ( except $60 worth), but has risk only
down to 40 (he will have $4,000 in his bank account at the end of one year even if the
LEAPS expire worthless).
This strategy of buying in-the-money LEAPS and putting the difference
between the LEAPS cost and the stock cost in an interest-bearing instrument is an
attractive one. It might seem it would be 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