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LEAPing Forward

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With August expiration looming on Friday, it is time to revisit the issue of the new LEAPS (2005 expiration) that have been issued in recent months and those that are waning in usefulness, those that expire in January (the 2003s). Normally I would defer this discussion to our weekend LEAPS column, but with today's dramatic reversal in the broad markets, I foresee that we'll have plenty discuss aside from this peripheral issue.

For those of you that have questions about the actual process by which the new LEAPS are issued and the symbols change for the front-year (2003) LEAPS, let me refer you to the article I wrote in late May.

Out With The Old, In With The New

LEAPS traders typically take positions in order to profit from longer-term moves in the equity market, as LEAPS provide us with the attractive leverage benefits of options, while insulating us from the detrimental effects of time decay attendant with short-term options. Simply put, LEAPS give us staying power for a directional move without forcing us to constantly fret about the loss of time value in our option holdings.

The catch is that when LEAPS draw within 5-6 months of expiration, time decay starts have a much more pronounced effect on those front-year LEAPS premiums. In order to insulate ourselves from this increasing time decay effect each year, we start rolling out of the front-year LEAPS at the end of August, focusing more intently on the out-year LEAPS, 2004 and 2005 in this case. Certainly, there is greater leverage available from the shorter-dated LEAPS, but with only 5 months left until the 2003 LEAPS expire, any significant pause in the fledgling rally will have a much more pronounced negative impact on these near-term LEAPS.

Let's take a quick look at an example from the current LEAPS Portfolio, as I think it will really drive the point home. We've been trying to game the bottom in the Technology sector via LEAPS on MSFT. I think we've managed to grab a solid entry point into the play, and the positive action in both the stock and the broader market today would seem to bear that out. But looking at the charts below, you can see how there have been much wider swings in the price of the 2003 LEAP, relative to the 2004 and 2005 LEAPS, although this is partially due to the fact that the 2003 LEAP is a lower strike.

Daily Chart of MSFT JAN-2003 $45 Call

Daily Charts of MSFT JAN-2004 and 2005 $50 Calls

So let's do some quick math. The lows that I've used for our measurement are those that occurred on August 2 and 5, with MSFT putting in an apparent bottom near the $44 level, while the highs I'm using are those levels that have been consistently tested over the past week. It's not so much the price range that catches my attention, as it is the percentage moves in the LEAP prices. Here's how the math works out:

LEAP       Price Change    % Change
2003       $3.10             +53.4%
2004       $2.60             +30.2%
2005       $3.30             +28.2%
It doesn't take a rocket scientist to see that the better return on capital invested over the past 8 trading days would have come from the shorter-dated LEAP, with a more than 50% return. But we need to remember that leverage works in both directions. What I'm more concerned with in managing a trade is the control of risk, rather than just the eternal question of "How much can I make?" Note that the current stop on this play in the LEAPS column is set at $43, just below the $44 low that I referenced above. So what that means is that if we are playing with the 2003 LEAP and protecting ourselves with that $43 stop, we need to be prepared for a far more substantial decline (in percentage terms) than if we were using the 2004 or 2005 LEAPS. Put another way, it is easier to control risk with the longer-dated LEAPS, because time value is a larger portion of the premium.

Remember that we aren't talking about which option to pick for a short-term trade, as we want to hold our LEAP for an extended move, where we can stomach the volatile swings in the price of the underlying, without watching the value of our position swing up and down by 50% or more in a period of only a few days. And then there's the issue of staying power. What if MSFT were to cease its ascent near current levels and meander sideways for the next couple months? Guaranteed the 2003 LEAP would lose significant value, but the longer-dated LEAPS wouldn't suffer this premium erosion due to the amount of time remaining until expiration.

This discussion is just the long way of showing why we are going to be phasing out the 2003 LEAPS from those plays that we cover in the LEAPS column, placing our emphasis on those LEAPS that will not be subject to significant time decay in the months ahead. Obviously we can't just make this transition overnight, especially with several open Portfolio plays. We'll continue to track all of the listed LEAPS for the duration of each of these open positions. But all future Watch List candidates will be listed with only the 2004 and 2005 LEAPS. Additionally, for those of you looking to initiate new positions in any of the featured Portfolio plays, I would recommend not using the 2003 LEAPS from this point forward.

Hopefully this process doesn't leave anyone confused. If you do have any questions on the topic, feel free to send me an email gaps or inconsistencies in the process and the reason for our transition. Addressing this issue during the week leaves us free to focus on the markets and our actual plays in the weekend edition. And from where I sit, it looks like we'll have plenty to talk about this weekend!

Have a great week!

Mark



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