Quote from cnms2:
Besides the drawbacks you mentioned, high premium and large slippage, I don't like LEAPS for other reasons too: low open interest, high implied volatility, susceptible to large loss in case of takeover or bankruptcy. If the underlying gaps down you can't sell options on them for a meaningful premium or you risk to sell a too low strike and lock in your loss (if the underlying recovers quickly your gain is capped). Also, if the underlying gaps down your losses could be really large.
On the other hand using LEAPS forces you to limit the number of options contracts you buy, which is good if you don't use money management. In my opinion you do better reward/risk wise by buying the same number of contracts in shorter term options.
I can't verify this, but it seems that professional traders don't trade LEAPS, and I think they probably know better.
Options trading in itself has a negative expectancy, so LEAPS or not you still have to be correct in your forecast of the future price and implied volatility of the underlying.
Saying that selling premium on LEAPS is better, is similar to saying that covered calls are better. And this is true only under certain market conditions. It is not a conservative and low risk strategy, as many claim. If you draw the graph of the LEAP position versus the underlying price for various implied volatilities you see what your risks are. A covered call has the same graph as a naked put (so the same reward / risk). Selling a call on a LEAP call is a bull call spread with a high vega risk.
Okay, let me use an example most of us on this thread are familiar with and that is APA. Trader A buys 1000 shares of APA at a price of 66 and Trader B buys 10 contracts of Jan 2007 strike 70 at 9.00.
Trader A cost is $66,000 cash not using margin and Trader B cost is $9,000 cash, non-margin.
Looking at the last daily swing hi and low range is about 20 points.
Market trend is up so we can forecast a reasonable up move of 61.8 % using fibonacci to the 71 area.
Current delta with APA at 66 and using a ATM 65 strike the delta is about .60 so we will use .60 based on if APA reaches 71 the 70 strike for Jan 06 would be approx. .60 delta.
Trader A places a GTC limit order to sell to open 10 contracts of the Jan 06 70 strike
Both traders sell the Jan 06 70 strike when APA hits 71 area for approx 4.00.
Lets also assume for our example that APA closes at Jan 06 expiration below 70 so both trader A and B get to keep the 4.00 premium.
What's our return?
Trader A 4/66 = 6%
Trader B 4/9 = 44%
Both traders have reduced their cost basis by $4.00.
Trader A adjusted cost basis is $62.00
Trader B adjusted cost basis is $ 5.00
Now, lets do it again and assume both traders earn another $4.00 premium.
What's our return?
Trader A 4/62 = 6.45%
Trader B 4/5 = 80%
Both traders have reduced their cost basis by $4.00.
Trader A adjusted cost basis is $58.00
Trader B adjusted cost basis is $ 1.00
One more time, assume both traders earn another $4.00 premium.
What's our return?
Trader A 4/58 = 6.9%
Trader B 4/1 = 400%
Trader B has zero cost plus 3.00 net gain and can keep doing this until option expiration if he chooses.
Risk vs reward. Who has more risk?
Take a worse case scenario and terrorists bomb APA immediately forcing a loss of 50% of the stock value.
Using a price of 70 and a loss of 35 who lost more trader A or Trader B.
Trader A current cost basis at 58 , 1000 shares = $23,000 loss
Trader B, current cost basis zero, 10 contracts = no loss plus 300% gain.
Now take the other scenario that APA goes to 75 and both traders must cover their shorts and both traders decide to exit.
Trader A exercises to cash at $70 + 4.00 premium = $74.00
74/66= 12.12% return. Not bad.
Trader B Leaps are worth at least $14.50 using a .60 delta and probably more adding time value so lets say $15.00.
Trader B has a short cover loss of -5.00 and a 4.00 premium so a net loss of -1.00
What's Trader B actual return?
15.00 - 1.00 = 14.00 less 9.00 cost or 5.00 gain.
5/9 = 55.5%
For a few good traders like some here, short term directional trading works.
For the 99% of the other traders its a recipe for disaster.
I have done both, short and long term and in my opinion getting the return >of< your principal is more important than getting a return >on< your principal.
In summary, this board is made up of all kinds of traders, the best and the rest. lol
I put myself into the rest category.
For the rest, longer term cost more to play but your chances of winning are far greater than the short term.
You have only to go back and read the great posts to see what I mean.
I enjoy the healthy and polite debate.
hank
