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Bearish For The Rest of The Year\? Consider LEAP Puts

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It has been a long time coming, due to delays necessitated by the tragic events of September 11th, but I've finally found both the time and space to address the issue of LEAP Puts and how we might apply them to our never-ending quest for profits. As I've mentioned recently, I've had a number of emails requesting the addition of LEAPS Put plays to our LEAPS Portfolio.

I want to send my sincere thanks to all who have written, voicing their opinions and suggestions on whether it makes sense to utilize LEAP Puts in the current market, and possible strategies for doing so. Where possible, I've tried to integrate your comments into my ever-developing LEAPS strategy, and I hope all readers will benefit from your insights.

Prior to the terrorist attacks of 2 weeks ago, my personal belief was that we had passed the point in the current market decline where buying LEAP Puts was a high-odds strategy. Just as we need an equity to stage a substantial advance to generate profits when we purchase LEAP Calls, we need a substantial decline in order to profit from LEAP Puts. Hindsight is 20-20, and looking at historical charts, it is clear we should have been playing LEAP Puts aggressively over the past 18 months.

But that is water under the bridge. Instead of an economy flirting with recession, we now have one that has no hope of avoiding the official "recession" label that comes from 2 consecutive quarters of negative GDP growth. I expect this quarter to be the first, and only time will tell how many will follow it before we reach that final bottom. While the eventual TRUE market recovery will precede the actual rebirth of the expanding economy, I now feel that there will be ample opportunity to apply LEAP Puts to the pursuit of profits.

LEAP Puts are to LEAP Calls, as normal puts are to normal calls. The only difference being that there is more time involved. Entry points materialize in much the same way that they do for LEAP calls, only we are looking for overbought conditions on the daily and weekly charts to align with a rollover from significant resistance levels.

As with LEAP Calls, the Puts can be used for long-term to short-term trading, depending on the action of the underlying equity and the individual trader's time horizon and tolerance for risk. Before we delve into specific examples and potential trade candidates, we need to talk about the relative dynamics of the equity markets and their relative propensity to move up or decline.

Barring a protracted economic downturn like the Japanese economy has seen for the past 17 years, the broad markets have a natural tendency to move up over time. When we are applying bearish strategies, we need to remain cognizant of the fact that we are trading against the market's natural tendency. That means that we need to look a bit deeper into the underlying company's condition when searching for LEAP Put candidates. If we are taking a position for an expected protracted decline, we want to pick on a weakling that is not only unlikely to move up, but likely to fall considerably due to a worsening economic condition. But given the historic market decline over the past 18 months, there is no question that there are ample opportunities to apply both short- and long-term bearish strategies, particularly in the wake of a massive speculative bubble.

A study of historic charts for any equity or index will show that the downward moves are much steeper and faster than the rallies, meaning that our holding time for bearish trades should on average be shorter than that for bullish trades. That may lead you to ask the question, "Why use LEAPS? Can't we just use shorter-term (cheaper) puts instead of paying all that extra premium for the additional time?". The simple answer is "Yes", but there are some important advantages of LEAPS over near-term options.

First, an At-the-Money (ATM) LEAP will have a significantly higher Delta than that of a near-term option. While the latter should have a delta of approximately 50 (meaning that the option will appreciate 50-cents for each favorable $1 move in the underlying equity), the ATM LEAP may have a delta of 65-70, due to the greater time value.

Some readers have written to me, asking why we need to use LEAPS to capture these downward moves, pointing out that if we want to capture a high delta, all we need to do is purchase Deep In-the-Money (DITM) near-term Puts. This is actually a very good suggestion, but there are two strong reasons why it isn't quite as good in reality. First of all is the cost -- the cost of the DITM near-term option usually is higher than that of the LEAP. For example, if we were bearish on General Electric (NYSE:GE) and we opted to purchase a DITM Oct-45 Put, it would currently cost $9.70 or $970. By contrast, using the LEAP Put (I would choose the JAN-2003 $35 Put) would only cost $5.40 or $540. The delta of the two options would be very similar, and LEAP traders would have the added advantage that the LEAP would be far less susceptible to wild swings in volatility like we have seen over recent weeks.

But there is another, possibly more important reason why I like LEAPS over near-term options, and that is the time window. When you are trading a front-month option, you have a much narrower window of time for your trade to be proven correct. The move needs to take place shortly after you place the trade, because even though you may have a DITM option (which will suffer minimal time-decay losses), when expiration Friday arrives, that option is no longer viable and we would need to roll out to the next expiration month. The LEAP on the other hand, gives us the luxury of time and we can wait for the market to prove us right (so long as the stock doesn't move sharply against us, stopping us out of the trade).

So now that we've laid out the basic dynamics and motivations for LEAP Put trading, what are the basic parameters that I look for when searching for an attractive candidate? While this is by no means a comprehensive list, it is a good starting point.

  1. Earnings declining on a quarter-over-quarter basis, particularly in a deteriorating business climate. One example might be a company that is losing market share and suffering margin compression due to competition in a shrinking market. PC box makers like Hewlett-Packard (NYSE:HWP) and Compaq (NYSE:CPQ) certainly come to mind as satisfying this first requirement.
  2. Excessive valuation relative to either the rest of the market or other companies in the same sector. Just having a high P/E ratio isn't enough here, as we also want to see it as unjustified based on the company's recent earnings and revenue growth. A P/E ratio that is justified when the company is growing revenue and profits by 40% quarter-over-quarter will be utterly ridiculous if the growth slows to 20%.
  3. Of course we also need a stock price that hasn't already been hammered into the dirt. No doubt, shares of Nortel (NYSE:NT) are in trouble according to the first two criteria, but at $5, the stock just doesn't have enough downside to get our attention.
Just those three can identify some good candidates, but then we have to go to the charts. Entry points are important here just like in all trading and as I mentioned above, the picture we are looking for is daily and weekly Stochastics rolling over from overbought territory, and ideally this will occur at a major resistance level. Even better is if we have the monthly Stochastics rolling over at the same time, but I'll exclude that time-frame from our discussion tonight. Since we've already talked about GE up above, I'll continue to use it as my example, searching back through the historical charts to find what would have been a high-odds entry point to the downside. Needless to say, it didn't take long to find one! The Weekly/Daily chart montage shown below shows 2 attractive Put entries roughly a month apart.

Price began to roll over from the formidable $53 resistance level towards the end of May, with the added bearish weight of Stochastics rolling over in both the daily and weekly timeframes. As if that weren't enough, GE was banging up against the upper Bollinger band in both timeframes and the band on the daily chart was completely flat, indicating that this barrier wasn't going to give way easily. For those that missed the entry point, there was another invitation almost exactly one month later as the stock ran out of steam, posting a lower high with oscillators rolling over yet again.

A little research could likely unearth some even better candidates both in the past several months and in the current market. I've rambled on far too long for tonight, but we'll pick up the discussion next time, highlighting some potential LEAP Put candidates and attractive conditions for ushering us into new positions. Until then, remember that preservation of capital is our primary focus. Trade only when it is profitable to do so.

Questions are always welcome!

Mark Phillips
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