Option
Trading College
Subject:
The basics of trading L.E.A.P.S.
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Entry is Key...Exit is Everything! TM |
Session 1
A typical scenario: Let's say you want to be a millionaire down life's road...not a bad goal eh? Since you are the savvy investor type, you have found yourself a hot, undervalued, stock that you believe is going to be a huge winner in the next couple of years. Looking it over, you check the current price of its shares and they are trading at $85 each. You have $20,000.00 of your hard earned money to invest; and based on the current price, you can afford to purchase 235 shares at face value. You would love to buy all you can get; however, your current budget is limited, so you consider using margin which would increase your control to about 470 shares. There is a cost to consider when using margin and that's margin interest. Depending on your broker, it can range from 6% to 12% per year. The danger of using margin is that dreaded “margin call” should the stock drop in value. The along can devastate your trading capital since you are using 4:1 leverage and depending on your brokers requirements, you could get wiped out in a very short time.
Since you are certain that this stock is going to
the moon; and you are ready to hit the buy button with enthusiasm....whoa, wait
just a minute my bullish trading friend. There is another option to consider.
How would you like to control the stock with a fraction of your capital or even
control a lot more of it by purchasing
What are L.E.A.P.S.? The translation is: Long Term Equity Anticipation Securities. L.E.A.P.S. are option contracts with long-term expiration dates that can become gold mines if you learnt how to pick them correctly. Typically, L.E.A.P.S. are option contracts that are 1 - 2 years of time before they expire; and they can even go out as far as 3 years into the future. They expire like all other options; however, their expiation date is on the third Saturday of January for each year. They can be both calls or puts and they are a fantastic way to control the stock for as little as 1/3 the current price or you can control more shares for the same cash invested vs. buying the stock out right. Two things to consider here are:
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Session 2
Because L.E.A.P.S. are actually options, they suffer from time decay in addition
to price swings as the stock moves around. With
that out, you might be thinking, why would I want to do that? I'm glad you thought of that,
here is the reason. The
benefit to LEAPS is you can tie up a lot less money or control more shares of
the stock. Also, if the stock splits, your LEAPS split as well!—this is why you
want to use them on stocks that tend to split. And here is another benefit of
buying LEAPS, you can write covered calls against them and reduce your cost
basis to zero over time. But the best reason is LEAPS are options and therefore,
they
enjoy a larger return when the stock goes up due to the implied volatility all
options offer
verses just buying and holding the stock.
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Session 3 What strike price should you buy with LEAPS? There is the mystery. Your available cash and risk are the factors. I would recommend if you are looking for cash flow to buy Deep-In-The-Money (ITM) so you can effectively write covered calls against them faster. If you are not to concerned with cash flow and want a maximum return later on then buy (OTM) leaps to control more contracts. Remember that (ATM) is always the most expensive options to buy. Wait for a stock to come off support before you pull the trigger and confirm that it is definitely in an up trend. If the stock is going to split then wait until it splits and takes it typical post split depression before you jump on LEAPS. A good rule of thumb on when to sell that LEAP is when the stock is going to announce earnings and it’s a critical decision. You can sell the LEAP then resume if its favorable news or buy it cheaper if the stock dips. When
you get close to the end of the leap (less than 6 months) you will want to exit and
move to the next year out if you are still bullish as they are no longer leaps
and subject to accelerated time decay.
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Session
4
Here is where things will get interesting with LEAPS. First off you will need to do some study in our section on Covered Calls. Next you will need to understand the volatility issue of a stock and pick one that is not a major mover on news events etc. You should pick a stock with a strong up trend and one that has a consistent pattern to it. See charting for more details on finding these. Now that you have done your due diligence and are ready to enter into this type of trade I would like to give you some of the benefits.
Are you as excited as I am now? Once I unlock this secret you will be so amazed and the pressure of day trading will evaporate from you. Of course there is no perfect situation and with that said, I must caution you to seek the advice of your professional advisor before you invest in these types of strategies.
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Session 5
Ok, here is the meat of it. It's called a cash-flow cow :-)When you purchase your LEAPS, you are doing this because you are bullish long-term on the stock. The goal is to write short-term calls against you long-term LEAP and reduce your cost basis in the LEAP over time. When you are looking for the correct stock to play you want to keep in mind there should be a strong up-trend in place and the overall market is heading up with it. Here we go: Buy the LEAP when the stock is on a dip and at known support levels. Why? Because the LEAP will be cheaper due to implied volatility. Also, you do not want to be too premature in your assumption the stock is moving higher and get a bad fill which will extend the timeframe for you to use this strategy. Now that you have the leap in place the next step is to wait for the stock to rise in value and reach a known resistance level. Here is where you will sell the call against the LEAP. Why? Because the stock is shifting up and the calls are now fatter with premium due (of course) to implied volatility. For a more conservative approach you would sell the call two strikes above the resistance area. If you are watcher of the chart and market you could sell at-the-money calls since these will have the fattest premiums. Now, when the stock takes a break from the run up you buy back your calls and pocket the difference. Why should I do that? because you do not want to get called out since you do not own the stock you own the LEAP which is an option. It can get too complicated so do not let that happen. Even if you must buy the call back at a loss because you timed it wrong. You still exit the trade. Do not worry about the cost as your LEAP has increased in value many times more than the price of the call. If this is the case be patient and try again. Effectively done this strategy will reduce your cost on the LEAP to zero in about 1 years time. Then your profits are infinite as the LEAP grows. Kick in a couple of splits over the time you hold it and you will feel like you have Hotels on Broadway and Park Place -- cha-ching!
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Session 6
You should not run into too much trouble with these if you are patient and do not sell the calls on dips. Once you get good at these they can turn into a very lucrative "cash-cow" and generate monthly cash for you every single month.
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Profits Up!
The donFranko
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