Generating ensembles of multi-label classifiers using cooperative coevolutionary algorithms

Since the contract we are referring to in our example doesn’t expire until January 2010, you could hold on to this option for nearly that entire period without experiencing the kind of severe price degradation due to time decay that is so common to short-term options. That doesn’t mean that time decay doesn’t exist in LEAPS options; only that it doesn’t begin to have a significant impact on your trade until the contract is within three to four months of its expiration. The effect of time decay on an option is reflected in its theta value. Theta is a dollar value that indicates how much time value an option will lose in a single day.

As an option gets closer to expiration, the theta value will increase in the negative, reflecting the increase in time decay. This means that every day the stock doesn’t make a significant change in price from its current level, your loss will increase on an accelerated basis.

You can minimize the effect of time decay by either buying more time or by using an option that is deeper in-the-money.

149 Since stocks, in general, tend to go up over time, the LEAPS option

gives you a greater window of opportunity to let the stock move in the direction you need. With a longer time frame to work with, you can usually afford to loosen your stop loss prices to give the stock room to extend itself along the intermediate and primary trends more than you can do with short-term contracts. This way, if the stock moves the way you want in a short period of time, you have given yourself the choice of either taking your profit, which will still be attractive, or staying in the trade to maximize your opportunity in the upward trend. These are both good choices to have, and the more you can put yourself in this type of position, the more you will be able to realize attractive profits in your options trading.

Leverage

At this point, you may be thinking, “Minimizing time decay is good, but if I’m aggressive about the stock anyway and think it’s going to move, why do I want to pay that much?” Remember that successful traders do everything they can to put the odds of a successful trade in their favor. This is true whether they trade stock or options. Putting the odds of success in your favor means finding as many ways to minimize downside risk—whether it comes in the form of price volatility or time decay—as you can possibly take advantage of. Using LEAPS options is a conservative approach to taking advantage of short-term stock swings. AAPL’s price currently stands at $183.45, meaning that to purchase 100 shares of the stock outright for a short-term swing trade would require $18,345. If the stock makes the $18 you would make just under 10% on the trade. While that is a respectable profit, you are risking $18,345 on 100 shares. Buying the LEAP risks $2,950 on effectively the same position. If we assume an average delta value of .70, all other things being equal, the value of the call would increase $1,260 (.70 x 18 x 100). $1,260 / $2,950 = 42.7% return.

Quite a bit better return than the 9.8% received by buying the stock. A LEAP also allows time for the trade to develop if it stalls out in the first month or two.

This is the downfall of many options traders: They correctly forecast the direction of a move, but guess incorrectly about how soon it will happen. If you don’t buy enough time to allow a stock to move the way you want, you stand a much greater chance of losing money on the trade.

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Another aspect of this kind of short-term options trade that is often ignored is how quickly a stock is capable of making the kind of move you forecast. Buying too little time puts you in danger of losing money even if the stock does move the way you want.

Time decay begins to erode very quickly in the month leading to expiration; if the stock isn’t volatile enough to make up for that decay, you have no chance of success. The chart clearly indicates that AAPL can, and often does, move by $18 or more in a month. It is also capable of falling that amount or more. While it is making up its mind, it also does something that causes pain to all short-term option players. It can base for upwards of two months.

Suppose the stock reaches $200 shortly after you purchase the January 2010 $230 LEAPS call. You are now looking at a very handsome profit, but the longer expiration of the contract means that you can take the time to re-evaluate the stock and its trend.

There may be an opportunity to take advantage of a new extended upward trend. Purchasing a short-term option automatically

precludes you from maximizing the trend on this trade unless you repurchase another short-term contract, which generates higher commission costs; by comparison, a LEAPS option gives you the choice of bringing up your stop loss and staying in the trade with commissions attached only to the buy and sell side of that option.

Strategy III —

LEAPS Puts on Stocks You Own

Smart investors who hold long-term positions in stocks look for ways to minimize their downside risk whenever possible. Another strategy in addition to using trailing stop losses and position sizing techniques is to buy LEAPS on the stock you own. This technique is commonly known as hedging. A stock position is considered completely hedged when the number of put contracts is directly proportional to the number of shares. For example, if you own 500 shares of XYZ Company, you would need to purchase five LEAPS put contracts on XYZ to be fully hedged.

This strategy may sound counterintuitive at first blush. Why would you want to buy a put on a stock you already own? A put is, in essence, a bet that the stock will go down. Who would want to bet against a stock they already own? If you think it could go down, shouldn’t you simply sell the stock? The answer to that question

151 depends on the situation under which you bought the stock and

your overall investment objectives. If you are a short-term trader looking to take advantage of quick reversals and short-term trends, this strategy won’t help you. On the other hand, if you are a long-term investor who prefers to buy fundamentally strong companies and ride their long-term trends, buying a LEAPS put can be a useful, if somewhat expensive, way to minimize risk. Besides simply wanting to take advantage of long-term strength, one of the most common reasons investors might want to hold onto a stock for a long-term basis is to receive dividends. If you own a dividend-paying stock and sell the stock when it begins a downtrend and the stock pays a dividend during the downtrend, you will miss out on receiving that dividend. Many long-term, buy-and-hold investors rely on dividend income to help pay their living expenses. In this case, buying LEAPS puts is a practical way to guard against dramatic loss while still receiving your dividend income as a shareholder of record.

Another reason investors often hold onto stocks is because of the tax implications associated with selling a stock that has increased in value over a long period of time. Suppose, for example, that you have inherited stock from a recently deceased grandparent. Your grandparent purchased the stock 30 years ago when the stock was at a much lower price before stock splits, dividends, and so on.

Seeing the stock begin a downtrend is usually a compelling reason to sell the stock, but in this case it could result in a massive tax liability due to long-term capital gains. It may not even be a stock you inherited—maybe you purchased a stock 10 years ago that has since split several times and increased dramatically in price.

Anytime you are in a situation such as this and you don’t want to incur the immediate tax consequence associated with selling out of the stock, buying a LEAPS put could be an attractive approach to take. Let’s consider an example of a situation where a LEAPS put might be a good strategy. Look at Figure 6.8.

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Figure 6.8

In the above example RIMM has experienced an extremely attractive upward trend over the last 4½ months. With very strong fundamentals, this is a stock that many long-term investors would consider as a good position to hold onto. Suppose that you had purchased 500 shares of this stock in early February of this year and had been enjoying this run, but you are beginning to be concerned about the overbought state of the stock. You don’t want to sell it because of its strength and you believe that the stock will continue to show overall strength for the long-term. Buying a LEAPS puts is a strategy that could help you minimize any downside risk you may encounter in the short-term and stay in the stock to take advantage of its long-term strength. Look at Figure 6.9.

Figure 6.9

This table shows the LEAPS puts that are available for RIMM. The stock is currently just below $143 per share. You could purchase the January 2009 145 put for $24.85 per share, or a total of

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$2,485.00 x 5 = $12,425 expense for five contracts to completely cover your 500 shares of RIMM valued at 71,225.00. If the stock experiences a short-or-intermediate downtrend, which is likely at some point in the next year and a half, and drops below $47.50 per share, the value of your LEAPS puts will increase in value; it should offset a portion of the decline in value of your 500 shares during that time. If the stock begins a new uptrend after this decline, you can sell the puts back to the market, pocket your gains, and purchase more shares of the stock to take further advantage of the uptrend.