Option Investor
Tutorial

Long-term Equity Anticipation Securities or LEAPS are basically long-term options that allow an investor to capture much of the price movement of a security with a greatly reduced investment.

A LEAP option can allow up to 24 months of time for investor speculation although we normally utilize only a portion of that time in the LEAPS Trader.

LEAPS options expire in January of each year but can be purchased and sold at any time.

A LEAP option has a stated strike price generally in $5 increments corresponding with the price of the underlying security.

For instance a stock trading at $50 will have available strike prices at $5 increments from approximately $40 to $75.

Using GE as an example at $36.50 in Dec-2004 the prices for GE LEAPS are shown below.

Jan-06 $30 $7.30 Jan-07 $8.20
Jan-06 $35 $3.60 Jan-07 $4.90
Jan-06 $40 $1.30 Jan-07 $2.65
Jan-06 $45 $0.40 Jan-07 $1.30

With LEAPS your risk is limited to the price you pay for the option but unlimited as to potential gains. Using the GE example above you can see that buying the Jan-07 $40 LEAP for $2.65 would give you two years of price appreciation potential for GE for a very modest price.

With LEAPS everything is priced in 100 share lots. Using the GE Jan-07 $40 LEAP at $2.65 it would cost you $265 plus commission of normally less than $10 to enter the position. That is your total risk for the rest of the trade. If GE fell to $20 and your LEAP expired worthless your total cost would still only be $265.

Your upside potential is unlimited. Should the economy explode and GE run to $75 over the next two years the Jan-07 $40 LEAP would rise to $35 in value, $3500 per LEAP contract.

At expiration in January-2007 you have the option to sell the leap outright for any gain in price or exercise the LEAP and own the stock at $40. It is your choice, you are in control.

LEAPS are a very conservative investment but they still have risk, which is limited to your investment. Your risk is that the stock will not rise over your strike price during the remaining time period.

Your risk is greater the farther away from the current stock price you chose to purchase a LEAP. For instance, purchasing a $40 LEAP on GE would be a fairly safe bet but purchasing a $70 leap would be foolish. The odds of GE doubling in price over the next two years are far less than simply increasing $10. Your actual cash at risk would be much less at $70 with the LEAP costing only about $0.10 ($10 per contract) but the odds of the $70 price being reached are very small.

Investors must weigh their anticipation of gains in the stock price against the price of the various strikes when determining which strike price to purchase.

There are multiple strategies we employ at LEAPS Trader to reduce our cost in the position and in some instances the final cost will be zero. Highly volatile stocks will carry higher premiums than the GE LEAPS profiled above. This is due to the greater chance of a larger move in the stock price. In LEAPS a low price is not always a better investment and most times a high price is also less desirable. We endeavor to find the LEAPS at the right price to produce a high probability of profit.

LEAPS have a lifespan of up to two years but we will seldom hold a position for more than 3-5 months. Normal markets cycle every month or so with alternating periods of buying and selling. In the rare case where a market does maintain a positive trend for months we would also retain our positions until that trend breaks.

We view LEAPS as the equivalent of investing in the stock. We do not "trade" our positions but invest in stocks with the potential of making a decent move. We would tend to avoid very high volatility stocks due to the high cost of the LEAPS and the unpredictable trends.

LEAPS Trader strives to produce repeatable profits of 50% or more on every position. With an average life span of 3-5 months this will allow investors to double the money they have in LEAPS each year. We do not recommend that investors allocate all their funds to LEAPS but only that portion of their funds considered as risk capital. We try to minimize risk whenever possible but as in any form of investing there is always risk.

LEAPS Trader will strive to maintain a portfolio of 10-15 positions in positive market cycles and as few as five positions in negative market cycles. The portfolio size will range from $7000 to $12000 for one contract of each. No investor is obligated to enter any position and should only enter those that appeal to them personally. Investors with a larger capital base can increase the number of contracts per position.

The average price of our LEAP positions is just over $5 per share, $500 per contract. We will spend more when entering positions on stocks like EBAY ($10-$12) but only in rare occasions.

Ideally we want to enter LEAP positions on a pullback in the market/stock. In some cases we will enter on breakouts when the market refuses to cycle. By waiting for market cycles this gives us a cheaper price and many times a lower strike on the LEAPS. It also gives us a safer entry in terms of risk.

New plays are normally entered from the potential targets on our "Watch List". The Watch List will contain from 5-20 potential stocks that we are interested in owning if our price target is reached. Each stock will have and price target that serves as an entry trigger for the suggested LEAP. You will always know in advance what stocks we are targeting, the entry price trigger and the suggested LEAP for that position.

New plays are sometimes produced by news events in stocks that are not on the Watch List. If a news event occurs that produces a buying opportunity it will be highlighted in the newsletter or by email if necessary. Again, we do not trade LEAPS but view them as a reduced price short-term stock investment. As such we sometimes enter positions when everyone else has lost interest in the stock.

Generally the majority of our LEAP investments will be in LEAP Calls. We will periodically enter some positions on LEAP Puts but only on rare occasions. Should the market develop a downward bias we will increase the ratio of puts to calls but the majority of our emphasis will be on stock picking not trading the market. As a rule the majority of investors only invest on the LONG side of the market. We would rather wait patiently with the majority of our capital safely on the sidelines in times of market stress in order to be ready for the next bounce when it occurs.

The game plan is to double our capital each year and that requires patience and restraint in times of market stress and the willingness to enter positions in volume when the time is right.

LEAPS are options and as options they offer several ways to reduce risk associated with the investment. Normally this risk management comes in the form of buying a protective short term put as insurance against our long-term positions. This limits our downside risk while maintaining our unlimited upside potential.

In very few cases we may sell short-term covered calls against out long-term LEAPS to reduce our cost in the long-term position. We may also a bull put spread in order to reduce the cost of our Call LEAPS.

In times of impending market stress where overhead resistance levels and calendar cycles converge we will invest in short term index puts to profit from those market cycles and further protect LONG positions.

Primarily our main risk avoidance tactic will be purchasing a short-term put to limit risk on our long-term Call position. Using GE at $36.50 in December as an example we could enter a LONG LEAP Call position using the Jan-07 $40 LEAP Call for $2.65. As insurance we could purchase the March-05 $35 Put for $0.55 cents. This would give us 100% protection against any drop by GE under $35 unlimited upside on the LONG position. The concept on the shorter-term put is we need to be profitable by the expiration of that March put or exit the position completely. This gives us a three-month free ride to see if our entry decision was correct. If not we escape for a minor loss. If we are right then the 55 cents was cheap insurance. Generally on a stock like GE where volatility is very low we would not recommend an insurance put.

Where Put insurance will come in handy is in times of market volatility where we entered a specific stock on a dip and found out later it was not a dip but just a pause before the next leg down. In those cases we will make a decision and exit fairly rapidly and close both sides of the position.

On a position where a news event causes a sudden drop we will evaluate the long term potential and in some cases close the Put for a profit, sometimes for more than the cost of the long LEAP Call and then maintain the Call as a nearly free position in hopes of a long term rebound. Using the average cost of our LEAP Calls at $5.50 a sudden drop that spikes our insurance put to $3.50-$4.00 gives us a significant reduction in the cost of our Call. We can sell the put and maintain the call with a very small basis.

Sometimes a Long LEAP position can see a sudden spike in price due to a news event and that spike may be unsustainable. If we still want to be long despite the potential for profit taking we can sell a short term call against our long term LEAP (covered call) to capture the spike and then close the short term call when/if the stock price declines. This reduces the cost of our long-term position while maintaining that position. Should the stock price continue up we have locked in a profit and have reduced any further risk.

Legal Stuff

The results posted for the LEAPS Trader are hypothetical. The performance numbers shown are based on trades subscribers could enter based on our guidelines. They are based on the price when the play was initiated by LEAPS Trader, and the price when dropped by the LEAPS Trader. LEAPSTrader.com cannot guarantee that any person bought or sold the actual security or option for the prices listed in the newsletter, or on the Web Site. The entry price listed in the newsletter and on the Web Site for the Leaps Portfolio is the option price at the time the stated entry criteria for the play is met. The exit price listed is the option price at the time the stated exit criteria for the play is met. In the event the play is entered or dropped by the newsletter without the entry/exit criteria being met the closing price for that day will be used. Investors may receive greater or lesser returns based on their trading experience, timing of trade entry/exit and market price fluctuations. The prices listed are for reference only and are in no way intended to represent an actual trade, entry price or exit price.