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There are several ways that LEAPS options can be used; these strategies make LEAPS options attractive for virtually any trading system. This section will outline each strategy and the generally accepted best way they can be used. You may not necessarily use all of these strategies or find them applicable to your goals and trading style. That’s okay! Go through each one carefully and think about how it may apply to your trading system. Odds are that at least one of the following strategies will be a good fit for your trading style and goals.

You may even find that they are all attractive for your needs.

Note: The strategies listed here are not comprehensive. There are other, very advanced strategies for using LEAPS options that are beyond the scope of this material.

Strategy I —

Using LEAPS as an Alternative to Owning Stock

For many traders, one of the challenges of stock trading lies in the considerable capital required to purchase shares of a company. If a stock that trades at $50 gives a good buying signal, for example, it would cost you $5,000 to purchase 100 shares. If you are starting your stock trading with a small amount of capital, this could represent a large chunk of your trading account. Although you can purchase stock shares in any quantity you desire, the sizable amount of money required to take advantage of significant moves in stock price

represent a significant stumbling block for many traders.

143 One of the things that makes options trading attractive is the

smaller capital outlay required to purchase a single contract. A call option on the $50 stock in our example may only cost $5 per share, requiring only $500. If the stock moves up, the leverage associated with your option will cause the price of the option to increase in value faster than a proportionate stock position. The downside risk of short-term options, of course, is that if the stock doesn’t move the way you need before the contract expires, you can lose a significant chunk of that $500, or even all of it. LEAPS options provide a wonderful alternative to owning shares of a stock, with two added benefits: They also take advantage of leverage when the stock moves in your favor and they are affected to a much smaller degree by time decay than shorter-term options.

Since LEAPS contracts last for a period of six months to three years, buying a LEAPS contract gives you the opportunity to take advantage of the longer-term intermediate and primary trends without having to invest the larger sums of money it would take to buy the stock outright. Look at the stock chart in Figure 6.1.

Figure 6.1

In this example, let’s assume it’s May 2008 and this is the chart we have before us. AAPL has experienced a significant upward trend since March. The 30 sma and 50 sma are well below the price indicating continual strength of the trend. We make the assumption that AAPL will reach its 52-week high of $202 and then Steve Jobs

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will do a three for one split sometime in December. You could buy a two to three call option or, in anticipation of AAPL’s continued dynamic behavior, purchase a LEAP that expires in January of 2009. Let’s look at the two alternatives. The rules for short-term options are fairly explicit in that, unless you are a seasoned options player, you should stay conservative and buy one strike price in-the-money.

Figure 6.2

From Figure 6.2 you can see that the July 180 calls have a bid of $14.55 x $14.75. Those are expensive options…but not when compared to the price of AAPL at $183.16. That is probably a good trade and given the current trend should return a profit on the position. Unfortunately, it does not last through the opening of school season, when many computers are purchased and it expires prior to our anticipated split in December…again a month where a lot of computers are purchased. A LEAP may be a better alternative.

Figure 6.3

In addition to costing less than a stock, LEAPS have two other attractive attributes. The delta on a LEAP is more generous than a regular option and theta is less severe. That means all other things being equal, a LEAP goes up in value faster than a two to three month option and decays more slowly.

145 Further, if we follow the rule, except in special circumstances, to

only buy options that have a delta greater than .50, the Jan 10 230 LEAP calls have a delta of 50.42. They are actually five strikes out-of-the-money. Still, every time AAPL goes up in price $1, the LEAPS go up $.50. If we buy one strike price in-the-money on the LEAP, the delta is 68.13. Using delta alone to calculate leverage presents a distorted future price calculation. It does not take into account the amount of time contained in the option contract.

Knowing the stock, and being aware of business cycles throughout the year can be extremely helpful in determining if a LEAP is more advantageous than a regular call.

Just as with short-term options, LEAPS provide leverage that increases your profit opportunity as a percentage of the capital invested when the underlying stock moves in the direction you forecast. This leverage isn’t quite as high as it would be on a short-term contract because the time remaining on the contract improves your odds of getting the move you want. This translates directly to the premium you pay for the LEAPS contract; it is also reflected in the delta value of the contract.

Clearly an option has greater leverage than a LEAP or the stock itself. The great unknown is “what will the stock do between now and December?” If the stock continues to trend upward as it has for the last two months, then pure calls are the better selection. If the stock maintains its annoying habit of pulling back radically as it did in August of 2007 and again in November of 2007 (see Figure 6.4), then a LEAP is clearly the safer and better choice.

Figure 6.4

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The number of variables in the stock market, the economy, related costs of goods sold and other factors is almost unlimited. Making a decision based on leverage or rate of return between two options with largely different time frames is probably extremely short sighted.

The best basis for making a decision on any investment is to

consider your overall objectives and tailor your strategies accordingly.

Remember also that LEAPS have two disadvantages when compared to owning a stock. LEAPS decay with time and should a company declare a dividend, the holder of a LEAP does not participate.

One approach to maximizing profit in a good trade that professional traders use frequently is scaling in to a trade. This refers to placing a smaller amount of the total capital you would be willing to risk in the trade at the beginning, when the risk of failure is the highest.

If the stock begins to move the way you want, you can add to your position until the entire amount you were originally willing to risk is in the trade. This is a way to reduce risk and still take advantage of a long trend. LEAPS options offer the same opportunity to scale into a trade as if you had purchased the stock itself.

Consider the AAPL example. If an investor is willing to spend $183 for 100 shares of AAPL and the LEAPS at the $230 strike price were $29.50, that’s roughly 16% of the cost of the stock. Suppose the stock reached its initial profit target and your technical

indicators signaled that the upward trend was likely to continue.

You could easily add another contract and achieve the same scaling in effect keeping the LEAP leverage in place.

Strategy II —

Using LEAPS Options in Place of Short-Term Options

Most traders who use LEAPS think of them primarily as vehicles for longer-term investments. In this case, traders use LEAPS to take advantage of option leverage, while approximating the nearly infinite period of time a stock can be held, while still positioning themselves for attractive short-term profits. However, conservative traders can also use LEAPS as an alternative for short-term options contracts. This approach applies a logic that is the reverse of using LEAPS in long-term plays; it sacrifices some of the leverage associated with the option in favor of the ability to minimize the time decay associated with short-term options. Look at Figure 6.5.

147 Figure 6.5

AAPL made a strong move over the past two months moving up some $60 per share. In the past three days it has pulled back.

If the stock reverses and continues its upward trend it may reach the $200 mark achieved in late December

A simple options trade here would be to buy a call contract with a duration of one to two months so as to maximize the potential reward if the stock makes the $18 move between the current

resistance to its next resistance. The downside risk on such a trade, of course, is that if the stock doesn’t move up quickly, time decay will erode the value of your contract to the point that you would have to absorb a large loss. Many traders understand and accept this risk, but don’t think about ways to manage the trade beyond using a stop loss or to make sure the trade is only a small portion of their capital. Using a LEAPS option in place of the short-term option is a good way to add yet another layer of risk management to your trade; it minimizes the effect of time decay while still putting yourself in position to reap a handsome profit if the stock moves the way you want. Let’s compare using a LEAPS option versus a traditional call option using an example. Look at Figure 6.6.

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Figure 6.6

If you were to purchase the July 180 call, you would pay $14.75 per share.

The January 230 LEAPS (delta > .50) are more than double the call price at $29.50 because of the additional time. If we are looking for the stock to go up by December, you could hold onto the LEAPS without experiencing hardly any negative effect from time decay.