By Mark Phillips
As I mentioned over the weekend, I want to take the time to comment on the different factors that should influence how we pick the appropriate strike price when contemplating the purchase of a LEAP. Let's assume for the sake of argument that you have already done all the fundamental research and technical analysis to convince yourself that a given stock is poised to deliver a sustained upward move over a period of several months and is currently trading at $23. What strike should we trade? What expiration year?
Let's deal with the expiration issue first. The simple fact is that if we are targeting LEAPS for a long-term move, we want to insulate ourselves from the effect of the passage of time, and my preference is to buy as much time as possible. For most equities, that is now the 2004 strikes, although those LEAPS on cycle 3 won't have their 2004 strikes released until the end of July. While there may be occasions where it makes sense to use the shorter-term LEAP, it is hard to go wrong with buying as much time as you can afford. The simple math that underlies this conclusion is the amount we end up paying for each month of time we purchase with our LEAP.
For the sake of example, let's look at the EMC $30 LEAPS for 2003 and 2004 (I would have used the $25 LEAP as it is the strike we would prefer to purchase, but there is no $25 strike available for 2004). Purchasing the 2003 LEAP for $4.00 gives us 18 months of time at an average "time cost" of 22.2 cents ($4.00/18) per month. But the 2004 LEAP at $6.20 only costs 20.6 cents per month, since it is good for a total of 30 months. It may seem like a small amount, but in the trading game, we need to stack as many factors in our favor as possible. If we are contemplating selling covered calls against our LEAP, then that lowers our monthly carrying cost of the LEAP and makes it easier to pay it off by taking in premium. The intangible effect of buying as much time as possible is that we give ourselves an extra year to be right and for the underlying stock to appreciate significantly.
The issue of which strike price to select is more dependent on your intention for the trade. If you are just looking to purchase the LEAP and ride the equity higher, then the best selection is typically one strike out of the money. In the case of EMC, with it trading in the $20-21 range, I would look to target the $25 strike. Knowing that LEAPS have a higher delta than short-term options of the same strike, even though it is one strike out of the money, the $25 strike likely has a delta close to 50, meaning that we should see a nice appreciation in our LEAP as the stock begins to move upward.
If however, we are intending to reduce our cost basis (preferably to less than zero) by selling covered calls, it may make more sense to buy the $20 strike, which is slightly in the money. The reason for this is our established policy of only selling short-term calls with a higher strike price than our LEAP, which keeps us from having to utilize margin on the combined position. Remember that most brokers will treat covered calls on LEAPS as a spread trade, selling a higher strike than the LEAP we own gives us a debit spread, and most brokers will not require any margin to maintain that position. So buying the $25 LEAP on EMC will allow us to sell the $25 front-month calls which will still have some decent premium for us to sell as the next upward move runs out of steam.
For those of you unfamiliar with the term, delta refers to the degree of movement we can expect to see in our option for a given movement in the underlying stock. If our option has a delta of 50, that means that it will move $0.50 for each $1.00 the stock moves. So obviously, when we are purchasing options, higher deltas are good, as our option will more closely match the movement of the stock as it appreciates. We just don't want to overdo it by buying an option with very high delta (i.e. greater than 90), as the option costs so much, we give up the advantage of leverage inherent to option trading.
Let's take a quick look at some actual data on EMC. With a current price of $20.30, let's look at some options and see what I am referring to in terms of delta. The AUG-25 Call is currently trading for $0.75, and has a delta of only 26, meaning that EMC would have to move nearly $4 to get a $1 movement in the option. That isn't too bad if we are trading for a short-term move, as it would equate to a 133% gain. But with recent market developments, that seems more like a gamble don't you think? Instead, let's look at the JAN2003-25 LEAP, currently trading for $4.00. The delta of that option is 61 (greater than 50) and looks like a pretty good deal, provided the stock quits falling. The same $4 move in the price of EMC will yield (theoretically) a $2.44 appreciation in our LEAP. While the percentage movement in our option is smaller (61%), the dollar movement is significantly larger, putting greater profits in our account while giving us even more time to watch our LEAP appreciate.
You can see how this equation really favors the holder of LEAPS when selling covered calls. Since the LEAP has a higher delta, it will always appreciate faster (on a dollar basis) than a shorter-term option of the same strike price. Even if the stock appreciates sharply, forcing us to buy back our covered call at a "loss", the gain in the LEAP will far outdistance the "gain" in the short-term call, leaving us with a net profit in the overall position.
What is really important here is to know what our plan is before initiating the position. We need to know what our exit strategy is for any trade we initiate, but with LEAPS we also need to know how long we intend to hold the position and if it is strictly a buy-and-hold approach or if we will use a spread technique to try reducing our cost basis. Hopefully this quick discussion gives you an idea of how to factor expiration cycle and strike selection into your decision process.
I'm just about out of time for this evening, but I know you're dying of curiosity about what is happening with our AOL trade. Remember last weekend, I said things were going fine, and we should have nothing to report this week. Well, boy was I wrong! AOL actually dipped right to our $48 stop during the day today, and I almost had to close out the whole position. But fate was kind to me, as buyers came to the rescue at the close. So those who are waiting for the real-world description of a LEAPS covered call trade gone bad will have to wait just a little longer. I think it's a foregone conclusion that the JUL-$55 call will expire worthless, but now we have to hope that the stock will hold above $48 so I can repeat the process for the August expiration cycle. Stay tuned, and I'll do a full update to the AOL trade next week.