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Posts Tagged ‘LEAPs’

Option Basics – What Vega Means to the Covered Write

Vega measures the sensitivity of the price of an option to changes in volatility. Vega is the estimate of the change in theoretical value of an option for the 1% increase in implied volatility. A higher volatility means higher option prices while a lower volatility means lower option prices. Vega is the measure of changing volatility on option prices. A higher volatility means an expected higher price swings in the stock.

An increase in volatility will increase the price of options on the stock while a decrease in volatility will cause all options on the stock to decrease. The vega of a long call or put option is always positive while the short calls and puts are negative. At-the-money (ATM) options have the highest vega so they are most sensitive to volatility changes. The further an option goes ITM or OTM, the smaller its vega will be. As volatility decreases for ITM and OTM options, vega is unchanged for ATM options. Vega decreases when time elapses similar to call premium decay. This causes vega to be higher for long dated options than short dated options. Of course, LEAPs have a high vega so an increase in volatility will raise the time value of the option.

For example, a stock that is trading at $35 with a high volatility of .75 with a vega of 30%. The stock option will lose $.30 for every 1% decrease in volatility and gain $.30 for every 1% increase in volatility. If volatility decreases by 20 points, then the stock option will decrease by $6.00. This suggests that you do not want to buy any call or put with a high volatility. Vega can cause option prices to change even if the stock price does not change.

Typically, I do not use vega in covered call trades as I tend to only sell options on stocks below 40% volatility and usually in the current option month. However, vega is important if you use LEAPs as a replacement for stock in a covered call trade.

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Trading a Calendar Spread with LEAPS

Previously, we posted information on doing a covered call using a LEAPS option. Call calendar spreads are similar to a covered call. One part of the call calendar spread is buying a LEAPS call instead of owning the stock. Then, we can sell call options (like a covered call) with less time to expiration (the calendar part). For example, we can buy a call LEAPS with two years of time and sell a call option in the next month. It the strike price of the LEAPS is the same as the call sold, then you have created a call calendar spread. It the strike prices are different, then we have created a diagonalized calendar spread.

My preference is to buy a LEAPS that is in-the-money. This gives you a higher delta so you captured more of the stock price move. A good target is to buy a LEAPS call with a delta of 0.70 or higher. If the stock makes a strong up move, then you gain more profits in the LEAPS call. Also, ITM LEAPS give us more choices in what strike prices to sell the call. In comparison to a covered call with stock, we DO NOT want to e exercised in the LEAPS position. The reason is simply that we do not want to lose the time value of the LEAP call. You can buy an ATM or OTM LEAPS call, but your delta will be lower and it is more difficult to sell a call until the stock price moves up.

When I sell a call, I like to sell the shortest amount of time available because it will decay faster (more profit per day due to time decay) than a call with several months of time. I like to use the existing month and the next month for call sells. I like to sell an OTM call when holding a LEAPS because the call sold is all time value.

The bottomline: Your returns will be leveraged. For example, you may get a 3% return on a covered call but that same return will be 12% if your underlying is a LEAPS instead of stock. Since we are using LEAPS, if the short call strike price is above the stock then it will expire worthless. You can then sell a call against the LEAPS for the next month. If the stock price is greater than the short call, you can back back the short call or roll it up to a higher strike price.

FYI:  See the top 50 calendar spreads on the options caculator page.  This list is based on simple calendar spreads with the same strike price for lomg and short options.

How to Use LEAPS as Stock Replacement

Some investors are getting started with a small account.  However, these investors want to make some extra cash to pay some bills or to build up their capital.  They can sell calls on lower priced stocks as it takes less capital to purchase 100 shares of stock.  This is not the only way to achieve income on a smaller portfolio.  They can use LEAPS (long-term equity anticipation securities) as a stock replacement in covered call trades.

Just like a covered call trade, LEAPS (yes it always has an “S” which stands for security) can be purchased instead of the underlying stock which a call can be sold against to provide income.  LEAPS are similar to options except they have a longer time to expiration.  LEAPS usually expire from 1 to 3 years from the time of purchase.  The tradeoff is that you can purchase a LEAPS with 1-3 years of time at a lower cost than purchasing the stock.

The risk profile is very similar between a stock purchase or a LEAPS.  If you buy a stock for $50 then your risk is $50.  The same is true for a LEAPS.  If you buy a LEAPS contract for $20 then your risk is $20.  In both cases, your total investment amount is at risk.  The big difference is that LEAPS have an expiration date while stocks do not.  Since LEAPS have an expiration date, they can be purchased at a lower price than the underlying stock.  

When you purchase a LEAPS contract, you control 100 shares of the underlying stock.  Just like a option call, LEAPS give you the right, but not an obligation, to purchase the stock at any time before expiration at the strike price you purchased.  

For example, Pepsi (PEP) is trading at around $69.00 at this time.  Your cost to purchase 100 shares of UA will be $6,900.  You can purchase a Jan 2013 call at the $70 strike price for $4.35 per contract. This LEAPS will cost a total of $435.00.  This is a significant difference in the initial investment that is at risk.  The January 2013 call has 556 days until expiration.  You now have the right to purchase 100 shares of Pepsi stock at $70.00 anytime over the next 556 days.

To complete a covered call on PEP, you can sell one August 2011, 38 days til expiration, call at $0.84 per contract.  This is $84.00 in income for a total investment of $435.00.  This is a static return of 19.31% over 38 days.  This is extreme leverage that LEAPS offer to the investor.  If you purchased the stock instead of a LEAPS, your return would be 1.22% because your investment would be $6,900.  Also, your risk would be $6,900 for the stock versus just $435.00 for the LEAPS.  

The bottom line: LEAPS lower your total investment compared to the underlying stock and leverage your total return potential.  This is great for those wanting income when investing with a small portfolio or those wanting to leverage their return.

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