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Last Saturday, I was helping Optionetics in the Invest Fair at Suntec City, Singapore, to promote our 2-day intermediate seminar package. It was a big event and many people came to our exhibition booth, possibly because they were curious about why we were there and what we were offering. Anyway, to cut the long story short, there was one guy who appeared to be interested in our offer. So, I asked him whether he is an options trader. This person replied “yes.”  I then asked him what types of strategies he is using. This person said, “I am trading LEAPS.”  I said, “Hmm … (pause) … LEAPS? …. That is interesting. Do you know that you may have paid too much extrinsic value for LEAPS and sacrifice Gamma?”  This person said that he did not know what I was talking about. He asked “Gamble?  I don’t like to gamble.”  I said “No, Gamma – G-A-M-M-A.”  All right, this explains why I am writing this article.

What are LEAPS?

Before we evaluate the merits (and demerits) of using LEAPS, we need to first understand what it is. The definition of LEAPS can be found in the CBOE’s website.

“LEAPS, or Long-term Equity AnticiPation Securities, are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years.”   

Sacrifice Gamma when using LEAPS

Now, let me illustrate my points using a hypothetical example.

Gary is a great fan of IBM and he has tracked this stock for years. Gary has done his fundamental analysis and firmly believes that it is a company with sound fundamental and he is prepared to hold the stocks for long-term. Somehow, on 30 April 2007, Gary ran his Profitsource scan and spotted a good technical set-up on IBM using candlesticks and ADX/DMI (see Figure 1). Here comes the idea of combining fundamentals and technical set-up to create a potential trading opportunity.

Figure 1: Technical set-up for IBM on 30 April, 2007.
(click here for larger view)

The next step Gary needs to do is to consider what strategy he could use to take advantage of this opportunity. To keep the matter simple, let’s assume that he decides to use a long call as he notices that the IBM options are cheap. However, he is confronted with this dilemma – LEAPS versus. shorter-term option (for discussion sake, let’s use May07 option).

Figure 2 is an overlay of the trade details for May07 100 Call and Jan09 100 Call [LEAPS]. To make this comparison meaningful, let’s set the maximum risk to be $2,720 (which represents 2 x Jan09 IBM 100 Call). Of course, as a good trader, Gary would have addressed the risk first before looking at the reward. So, let’s assume that Gary is prepared to exit the trade when he loses half of the net debit.

Figure 2: Trade Details Overlay in Platinum

Take a look of the Greeks profile of the respective trades. The May07 100 Call position (Left Trade) can be translated into holding approximately 670 shares of IBM whereas the Jan09 100 Call position (Right Trade) can only be translated into holding 130 shares of IBM. You will also notice that the Gamma for the Left Trade is higher than that for the Right Trade. The reason is that front month options have higher Gamma than back months options. Of course, the trade-off when getting more Gamma is that Theta Decay.   There is another Greek which we cannot miss – Vega. You will see that the Right Trade has a higher Vega than the Left Trade, meaning that the Right Trade is more sensitive to a change in implied volatility than the Left Trade.

Sometimes, a picture can speak for thousand words. So, Figure 3 is a risk graph overlay projected to May07 expiration for both the Left and Right Trades.

Figure 3: Risk Graph overlay in Platinum

You will notice that that if there is a piece of good news on IBM so that it continues to go up till the May expiration, the Left Trade (in blue arrow) will generate more profits than the Right Trade (in green arrow).

So, let us see what happened on May expiration.

Figure 4: Risk and Volatility Graph

The Left Trade had a profit of $4,455 or a 168% return on investment whereas the Right Trade had a profit of $920 or a 33.8% return on investment only. In terms of risk versus reward, the Left Trade obviously offered a better bang for the buck than the Right Trade.

You may wonder what Gary can do after May expiration. If he is still bullish on IBM based on the technical set-up, he can use the profit from the Left Trade to buy another shorter-term option. For this purpose, let’s assume that he chooses a Jun07 105 Call for a debit of $4.30. Since Gary’s original allocated risk capital was $2,720, Gary could buy 6 contracts. In doing so, Gary has also locked in a minimum profit of $1,875 (See Figure 5).

Figure 5: Rolling forward to Jun07

If Gary were to choose and hold on to the LEAPS, how much risk has he assumed on May expiration?  If you think it is $1,800 ($2,720 - $920), wrong, it is not correct. The risk remained $2,720 because no profit has been taken off from the table. If IBM were to make a U-turn, the paper profit of $920 may well be returned to the market. As always, our job is to manage the risk. Not only has the Left Trade offered a better bang for the buck compared to the Right Trade, but also, using what Christina Dubois-Nugent taught me, “to use the house money to finance our existing trade.”  I believe that this is a good example.

So, will you still use LEAPS?  I guess it is up to you. But you may want to re-think. I am not suggesting that Gary has to use a May option here. Gary is an educated person so he knows how to deal with front month option. The point I am trying to make is that a shorter-term option clearly provides a better bang for the buck than LEAPS.

Remember, trade smart and not often!

Good trading!


Jack Wong
Contributing Writer
Optionetics.com ~ Your Options Education Site

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