LEAPS - Long-Term Equity Anticipation Securities

Patterns for Profits Newsletter - June 3, 2008

No we are not talking about the educational toy company. We are talking about making money in the options market. To be more specific we are talking about making money in the Long-Term Equity AnticiPation Securities (LEAPS) market.

LEAPS are publicly traded options contracts. But these contracts don’t expire for more than a year, often two years. You can purchase LEAPS for individual stocks as well as equity indexes such as the S & P 500.

The strategy involved here is that you believe that a stock or a sector of the market will move substantially in a given direction. But you cannot decide when. Rather than buying a series of options contacts you purchase or sell, at a greater price, a LEAPS option.

These options are usually touted as a means for the long term trader to access the options market. They are also a rational way to deal with a market move that has to happen but may take a month or may take a year. A LEAPS option also allows you to wait out the entire upward or downward run of a stock and take a greater profit than if you were forced to exercise an option because its expiration date is coming up.

It is of note that after a LEAPS contract goes under 9 months it becomes a regular option.

The standard reasons for trading in options apply to LEAPS, to buy low, sell high, protect stock holdings, to profit from a rise or decline in a stock price without buying the stock, or to increase income from underlying stock holdings.

Call, Put, Strike Price and LEAPS

The same terminology and rules apply to LEAPS as to regular options.

A call option seller (writer) has to obligation to sell and a put option buyer has the obligation to buy if assigned an exercise notice on or before the option expiration date.

For equity option contracts the shares of stock change hands but for index option contracts cash changes hands.

LEAPS Advantages

Index LEAPS purchases allow the buyer to participate in overall market moves at a lower price than by buying individual stocks. This certainly applies to purchase of all the stocks in an index.

The same ability to purchase at a lower price applies to buying LEAPS for individual stocks.

Like regular options contracts a LEAPS purchaser cannot lose more than the price of the option.

LEAPS and Variation on a Theme

As with any options trading the imaginative and resourceful investor will find value in anticipation of market moves using LEAPS. Here are three strategies for success with LEAPS.

Rolling LEAPS Options

Rolling LEAPS options allow very long term use of LEAPS to protect long term investments in an underlying stock portfolio or to participate in a long term run up of the market with less investment than with stock purchases.

A “buy and hold” variation on LEAPS is to purchase a Call option on an index with a strike date two years out. Then the trader will “renew” yearly by selling the same option (strike date and index) before the LEAPS converts to a regular option. The trader then “re-purchases” the same index with a two year strike date.

An alternative for a holder of an individual stock is to purchase a LEAPS Put option on that stock with a strike date two years distant. Again the trader will cancel the position with an “identical” option sale at a year and “re-purchase.”

This is also called an option roll forward or “the roll.” It allows an investor to hold a promising or protective position in the market at a relatively low cost. As with all options trading this strategy provides the trader with market leverage.

LEAPS in a Covered Call Write

For the more sophisticated investor, or should we say the more hard working and imaginative investor, there are more choices. One of these is using LEAPS in a covered call write.

A traditional covered call write is when a stock owner sells a Call on a stock he owns. His hope is that the stock does not go up “too” much so that he has to sell but that it appreciates a little and he collects his dividend as well as what he earned from selling the call. However, this strategy does not protect against downsize risk. The owner can also buy a put against the same stock to protect himself or might consider another possibility.

What if the investor does not buy the stock but purchases a LEAPS option contract on the same stock with an expiration date two years in the future. Then the investor sells a Call option against the same stock. The investor receives the same amount of money as if he owned the stock. In this case the return on capital investment is greater as the investor has only purchased the LEAPS option and not the stock.

The other advantage to this approach is that it limits the downside risk of the investments to the price of the LEAPS option minus the value of the call option. Usually this strategy is used in a neutral or bullish market but if disaster strikes you will not lose a large fraction of a large stock position.

Another strategy is to use LEAPS with collars.

LEAPS with Collars

This is a protective strategy wherein the owner of a stock portfolio hedges to set a maximum possible loss. As with all strategies against loss the use of a LEAPS collar can reduce your upside potential too.

An investor creates a collar by purchasing a put while simultaneously writing a call against a stock position. One buys one put and writes one call for every 100 shares of stock owned. The call finances the purchase of the put and the put protects against downside risk. If the stock goes up past the strike price for the call the investor has to sell the stock.

This strategy is used by owners of individual stocks. An alternative for investors interested in protecting against market loss is to purchase puts with LEAPS index options. This is a market wide strategy for protection against large scale economic risk.

This strategy is best used with a portfolio of stocks that are in stock indexes, namely large cap stocks. This alternative is a good protection against downside risk. However, because of the long term nature of LEAPS you collection on the put will depend upon the time of the strike of the LEAPS.

As with all options advice you will need to learn before you earn. There are many sources of information available including the SEC and the various options exchanges themselves. As with any options trading the imaginative and resourceful investor will find value in anticipation of market moves using LEAPS.

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Patterns For Profits Market Watch

The S&P 500 did break to the upside from the daily range pattern we showed you in the May Patterns for Profits Newsletter.

It is now trading around the original breakout area of 1402. If the S&P continues higher there is a potential for a larger AB=CD sell pattern to complete. We will be watching higher prices for this. The 1407 price area was a strong resistance area the end of this week. This area had been a previous support area that had been broken and was also the .50 retracement. Smaller intraday sell patterns had formed with completions into this area.

The Crude oil market traded as high as $120 and completed the daily AB=CD sell pattern that we had been posting. As it was approaching the completion smaller intraday sell patterns were forming as well, there were 5 minute butterfly sell patterns and 5 minute AB=CD patterns as well. This may be the highs for awhile in crude oil and should offer good trading opportunities.

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Patterns for Profits Trading Tips - Don't Change Horses in Midstream

This certainly applies to trading. There will be times that it will feel as though you could not hit the side of a barn if you were 10 feet away. Sometimes the markets will go through shifts or subtle changes in daily ranges or momentum in one direction or another and you may feel out of synch with the trading. Many times traders with throw out their trading method because of feelings of frustration or anger or just think it doesn’t work.

This can be a mistake for several reasons:

1. The trader can then be vulnerable to random trading; trying to hit something and then suffering unnecessary losses and increased frustration and anger.

2. There is nothing wrong with the trading method; it is just going through a cycle.

3. The trader abandons the trade method just before the next winning streak.

Keeping data or statistics daily on your trading method can be extremely helpful when the markets go through periods that are not conducive to your trade method. This will help the trader identify these cycles and also identify when a trade method no longer has an edge.

It will also help the trader realize that they must keep trading the setups and will help give them the confidence to do so. Generally, winning streaks are followed by losing streaks and losing streaks are followed by winning streaks. One thing that is impossible to determine or know is which order these will be in.

Murphy’s Law always seems to win in trading; as soon as a trader throws in the towel the trade method once again becomes effective.

If you have taken the time to study and learn a specific method in trading you should be able to determine the difference between a market cycle and something that no longer has an edge. Stick with classics like the AB=CD pattern, this is a timeless pattern deep rooted in market participant’s psychology and can be seen on charts dating back to the beginning of trading in this country. This pattern is found intraday for day trading as well as longer time frames for position and swing trading. The pattern is covered in detail in “Trade What You See – How to Profit from Pattern Recognition’ by Larry Pesavento and Leslie Jouflas, Wiley & Sons, 2007 and is available on our homepage www.tradingliveonline.com

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Leslie Jouflas
Kelly Hill