There’s more to long-term options strategies than LEAPs
In my never-ending quest to resist Wall Street’s “when in doubt, Buy LEAPS” mantra, I ran some numbers on some hypothetical ERTS trades. My goal was to see how calls of different time frames, when held for a month, perform in different stock moves. Using a starting price of 60 in ERTS, I compared Jan06 60 calls, May06 60 Calls and Jan07 60 calls.
I assume volatility holds constant, and I assume it’s just a passive position for a month (i.e., no hedging with the stock). Both of these assumptions generally advantage the LEAPS, particularly on the upside.
I looked at the trade in “dollar returns” and not “percentage returns” Why? Because each option has a 50ish delta when you initiate the trade, so your stock equivalent position is identical at the outset.
To see why this is the correct way to look at it, consider this. For the same dollar amount, you can buy either
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PowerRating) Nov 340 calls, or
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PowerRating) stock (both are $40). If GOOG goes down a mere 2.6%, you lose 25% of your investment in the calls. MEE would have to lose the actual 25% for you to realize the same loss. So I know it’s counter-intuitive in terms of capital requirements, but you should always look at option positions in terms of your “share equivalent” position in the stock. But I digress.
Anyway, here are the results of three ERTS call purchases. The top line represents the price of ERTS in one month; the results in the table represent the net dollar gain/loss on this passive trade.
So bottom line, after 1 month, the LEAPS outperform the Jan06’s if ERTS closes between roughly 56 and 67, otherwise the Jan06’s are better (or less bad on the downside).
So in other words, LEAPS make most sense if you anticipate a tight range in the foreseeable future, while the nearer month’s make the least sense. It’s no mystery why; the nearer the option, the greater the decay.
But if you anticipate I tight range in the stock, I would suggest there’s a better strategy. You can either naked sell puts, or if the risk/reward picture there is understandably troublesome, you can sell put spreads with defined risks. Instead of “losing less” as the LEAPS will do (and remember, it’s a losing trade no matter how you slice it with the stock below 61), there may be better alternative strategies that jibe with your opinion (which by definition when you buy a LEAP call, is “bullish, but not necessarily right this second”).
Adam Warner
Adam Warner is a proprietary trader for Addormar Co., Inc., specializing in option and derivative strategies. Prior to Addormar, he was an Equity Options Market Maker on the floor of the American Stock Exchange from 1988-2001. For more information about how you can receive Adam’s proprietary insights and trading setups, go to www.globaltechstocks.com