Option Investor
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LEAPS & Covered-Calls

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The number of ways to approach the options market is virtually endless. In fact, some traders believe derivatives are the most versatile financial instrument ever conceived. Since options cost less than the underlying stock, they provide their owners with exponential leverage that can significantly increase the profit potential in a variety of directional strategies. At the same time, history suggests that option buyers are going against the odds, even when they are correct in forecasting the primary trend. Why is this true? Because options are an eroding asset; the passage of time reduces the value of an option as it approaches expiration. Worse yet, the rate of time-value decay increases rapidly during the last few weeks of its lifespan, as shown in the graph below:

Option Time-Value Decay

Despite this obvious drawback of option ownership, it remains one of the most widely utilized trading techniques among retail market participants. The reasons for this condition are many but at the very least, option buying strategies are generally low cost with limited risk, and they are easy to understand and implement. The question then, is how we can reduce and/or take advantage of the effects of time-value decay in order to improve the success of this common approach to option trading.

LEAPS & Covered-Calls

One of the most popular strategies among conservative option traders involves the purchase of LEAPS; Long-term Equity AnticiPation Securities. For those of you who are not familiar with LEAPS, they are simply options with expiration dates far in the future. Currently, LEAPS are available for the year 2008 and, as with other standard equity and index derivatives, these unique instruments allow investors to establish bullish, bearish and neutral-outlook positions using standard trading techniques and combinations. In most cases, strategies involving LEAPS do not differ much from those utilizing shorter-term options and LEAPS can also be an ideal investment tool for the option trader who expects future growth in an underlying stock but does not want to make the substantial capital outlay required for entering an outright position in the issue. Since the expiration dates for LEAPS are months or even years in the future, time decay occurs very slowly with these options and they are much less affected by premium erosion; the fundamental drawback in the use of derivatives to replace stock positions. This unique quality allows these instruments to offer an effective way to benefit from a stock's appreciation without incurring the higher costs associated with the actual purchase of shares. Indeed, buying LEAPS can be a great strategy for risk-averse investors because it occupies the happy medium between aggressive, short-term option trading and simply purchasing the underlying issue.

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Covered-call writing is a simple hedging technique many stock owners use when they are trying to establish a conservative risk versus return profile while maintaining meaningful profit potential in neutral to bullish market environments. A person who uses this approach generates additional income by collecting cash for the sale of an option against a particular stock in his portfolio. What most investors don't know is this strategy can also be used with LEAPS. Of course, it differs slightly in that LEAPS are substituted for direct ownership of shares of the underlying stock, thus producing a combination of long and short options. The resultant risk-reward ratio is similar to that of a calendar spread; a technique that involves the sale of one call and the simultaneous purchase of another call, both on the identical underlying stock, with the same strike price, but with one option near-term and the other option further out. The theory behind calendar-spread profits is based on a neutral-outlook philosophy in which time erodes the value of the near-term option at a faster rate than the far-term option. Using LEAPS in a calendar spread can make the strategy even more productive because the premium in extremely long-term options is less affected by time-value erosion and any near-term volatility in the underlying issue can increase the cash received for the sold (short) options.

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