Option Investor
Educational Article

Fine Points of the LEAP Puts Strategy

HAVING TROUBLE PRINTING?
Printer friendly version

by Mark Phillips

Last week, we finally kicked off our discussion of LEAP Puts by defining some basic parameters that need to be satisfied and then examining a historical chart of General Electric (NYSE:GE) to demonstrate what we should be looking for in terms of entry points.

To recap, here are the basic features I want to see in a long-term put candidate.

  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.
With those guidelines, I went on a quest for possible candidates. Given the degree to which our precious markets have been beaten down over the past 9 months, you would expect to find slim pickings according to those 3 criteria, but I neglected to add the most obvious one -- the stock has to have LEAPS available. With a field of thousands of optionable stocks, and only about 300 with LEAPS available, you can see that the field of candidates is much narrower than we would like. But I did find some attractive candidates that, although they are not providing good entries at this point in time, I expect they will in the weeks ahead. In no particular order of preference, here are the 5 possible candidates I was able to locate.

1. AMGN - P/E=54, Rev. Growth=8%, Earn Growth=7%, Price=$59
2. TMPW - P/E=43, Rev. Growth=10%, Earn Growth=30%, Price=$27
4. EBAY - P/E=157, Rev. Growth=84%, Earn Growth=100%, Price=$51
5. DIS - P/E=97, Rev. Growth=-1%, Earn Growth=0%, Price=$19
6. KO - P/E=35, Rev. Growth=-3%, Earn Growth=20%, Price=$46

Like I said above, slim pickings! High P/E ratios combined with slow to non-existent growth is the kind of thing that gets my attention and motivates me to dive into the charts looking for possible entry points. Now is definitely not the time to be adding new long-term bearish positions on these stocks, but that time may come soon. Let's dive into one of these charts and see what we can find in terms of possible opportunities. It may seem that EBAY doesn't really belong in this list due to the fact that earnings and revenue are still growing at a respectable clip. While that much is true, I still have a hard time swallowing a P/E ratio north of 150, especially in the current market environment. Like the other candidates I listed, it isn't ready for us yet. But it could be soon.

Let's use AMGN for the purposes of discussion, as it presents the kind of picture we're looking for.

If I'm looking for a bearish long-term trade, AMGN is delivering many of the components I like. A high P/E ratio coupled with a slow growth rate tell me that the stock is vulnerable, and the fact that it is trading in the $50-65 range says there is plenty of downside available. All I have to do is pick the right entry point. Clearly, from the weekly chart, that is not right now, but the stock bears watching.

Let the weekly Stochastics bottom in oversold and recover back into the overbought zone. Judging by the past 3 cycles, this overbought condition should coincide with price rolling over near the descending trendline, likely in the neighborhood of $65. When the stochastics on the weekly chart reach overbought again, we'll want to drill down to the daily chart and look for stochastics to roll over from overbought in that timeframe to initiate the position.

As you can see, this is simply the inverse of the entry setup we look for in our LEAP Call strategy, and all of the rules that we have developed for that strategy apply equally well here. Stop losses are essential, and it is much easier to manage risk when we pick a good entry point.

To round out this discussion, I think a few words about exit strategy are in order. Assuming we get the entry we are looking for and are not stopped out of the play, the logical exit point will come when the weekly stochastics once again bottoms in the oversold region. This should correspond to a price in the mid-$50s, but it might make sense at that point to simply tighten our stop. Afterall, our long-term focus is that we expect the stock to break the $54 support level, and we would like to be on board when that occurs.

Unfortunately, we don't have any candidates that we can consider for pending entries, which makes our discussion more hypothetical than I would like. The other candidates I listed above are far from being entry candidates in the near-term as well, largely due to the sharp market decline over the past month. But I am still of the opinion that we could see some attractive long-term bearish trades setting up in the weeks ahead. I'll keep an eye on these 5 stocks and we can revisit the possibility of entering new trades when they get closer to providing us with the type of setup we are looking for. In the meantime, I'm always open to suggestions. If you have some other candidates that you think might provide good opportunities, based on the criteria I've outlined here, send them along. Making the search for attractive plays more interactive will likely be educational and profitable for all.

When I return from my honeymoon later this month, I'll finish off the topic of using LEAP Puts, but in a bullish manner. One of my long-time readers, Tony B. was kind enough to bring the idea to my attention in response to my request for reader input on the topic of whether it made sense to incorporate LEAP Puts into our strategies here. He chimed in with his opinion that we may be a bit too late to the game with LEAP Puts, but followed up with this insightful comment that I share with you just as I received it.

"However, before turning your back on LEAP Puts, why not look at LEAP Put Credit Spreads?? I've been trading these for some time now and have done very well with them. Often I leg into the Spread. Open the short leg when the stochastic on a weekly and daily chart are bottomed. Look for the daily stochastics to cross over and start up. After the stock has moved up (stochastic half-way up) I enter the long side. When stochastics peak and start to roll over, I buy to close the short and hold the long for the ride down.

As for candidates for this play, I've been using your list on Call LEAPS since I prefer selling as opposed to buying."

Does that concept sound intriguing to any of you? It did to me too! Thanks for sharing with all of us Tony. For those that are interested, tune in for our visit on October 24th, and we'll delve into all the nitty-gritty details in our quest to add one more powerful tool to our arsenal.

Until then, stick to your trading plan. The erratic markets of last month are starting to calm down, but that doesn't mean that the danger is gone. I still believe that the eventual bottom lies ahead of us and likely at levels we have not yet seen. Remember, patience is a virtue AND a trading skill!

Best Wishes for a profitable month!

Mark Phillips
Contact Support

Options 101 Archives