LEAPS, Calls and Spreads

Starting this week, you're going to be reading and seeing a lot about LEAPS, or long-term equity anticipation securities -- otherwise known as long-term options. The options industry is spending $4 million to advertise them and host seminars aimed at you -- yes, you -- to encourage you to use and understand LEAPS strategies.

So the Options Forum will give you a little jump with a quick-and-dirty explanation of LEAPS.

LEAPS are like any other options except that, rather than expiring in 30, 60 or 90 days, they expire up to two years from the current date. Otherwise you use them the same way. Buy calls if you're bullish; buy puts if you're bearish.

You'll hear that LEAPS are less risky because their longer time frame dampens fundamental risk. Well, yeah, that's true, unless you buy calls on a dog stock. The true advantage of LEAPS is that you can use them as a proxy to go long a stock without laying out too much capital.

LEAPS are slightly more expensive than other standardized options. The reason: The interest-rate component of options-pricing is inherently different over that longer time frame, and thus market makers will charge you more. Fear not, you're not getting ripped off by your brokerage, a market maker, or anyone else in the brokerage industry. If your chances of success using a LEAPS options are higher than normal, then the market maker has to protect himself. It's just a condition of the market.

The higher premiums, however, do have an upside. They provide great opportunities to sell options if you want to take in some premium based on your fundamental belief in a stock's future.

OK, we have other fish frying here, so that's as much as we're going to tell you. You want more info on LEAPS? Go to www.optionscentral.com for a schedule of seminars and a way to order the new LEAPS video.

Bad Covered Call

I recently started selling covered calls on Internet stocks. It's hard to resist, their premiums are so good.

I found it is normal to make 5%-10% a month (multiply that by 12 months and it's not bad).

What can I do if I sell a covered call and the price drops drastically? For example, I buy the stock at 40, sell a 45 call at 4. Which means I have 36 in the stock; the stock falls to 30. What can I do?

Dane Smith

Dane,

The thing about covered-call writing on Internet stocks is that -- while you may have made some money -- it likely won't work over long periods of time. The reason the premiums are so high is that the underlying share prices can move so violently, it's almost a lock to be assigned if you're written any type of option within 10%-15% of the at-the-money level.

Actually, in almost any defensive situation, covered-call writing is akin to cushioning a fall from the Empire State Building with a pillow from your grandmother's sofa.

The reason: Covered-call writing is best reserved for stocks and sectors that don't move violently. The idea is to take advantage of a lull in a stock to collect some premium.

So, what do you do if the stock swings like that? Enjoy the ride and check out a previous Options Forum piece on covered combinations.

Good Covered Call

I own Rambus (RMBS Quote - Cramer on RMBS - Stock Picks) at 99 and got caught in the recent earnings warning, and the stock now sits at 89 1/2. I am bullish on the stock long term, but think we might go sideways for awhile.

Would writing some calls be a good way to try and reduce my cost basis and cushion some of the blow if RMBS goes lower? I was thinking of selling the February 100's for $5.

If you were to implement such a strategy, would you sell the February or May calls? I was surprised to see there are not any March or April calls available, is this true?

Steve Cross

Steve,

Define "awhile" and then you'll be able to decide what month's option you should sell.

This situation almost is ideal for selling calls. The problem, as you point out, is deciding what month calls you would sell. My best advice, go one month out.

The March options, if they didn't exist when you wrote this letter, exist now. It's just that March is one of the months in Rambus' option cycle, so that month's options were added at the beginning of February.

Unfortunately, since you wrote this letter, Rambus has fallen even further, into the 70s, and the shares now look like an early tax write-off for 1999. Kiss Rambus goodbye.

Even More Covered Calls

I wrote a covered call at the money and it has since gone into the money about 8 points. Expiration is February. What would be a suggested strategy now?

I obviously made a mistake. Should I wait and buy back the call now or wait till closer to expiration? Should I roll into a future call, perhaps a LEAPS option? Or use cash and wait to write another call?

I would appreciate your ideas.

Ron Dunn

Ron,

Ouch! Sorry about the sour call strategy, Rob, but these market swings can get you. In my opinion, you should wait until as close to expiration as you can (Feb. 19! Mark it down) then buy back the call.

Although you don't specify what the stock is or what industry sector it's in, my thoughts are that anything that can see a 8-point climb from an at-the-money call is probably too volatile for you to be writing anything. So, since you asked, the best advice is to suck it up, buy back the call, and don't write another call on this particular stock until its volatility cools down.

Spread Solution

I have two questions about spread trades.

1. Is there any difference in closing out a spread as opposed to getting called out? An example: I purchase debit call on XYZ for February 50-February 55 when XYZ is 50. Three days (and three weeks before expiration) later XYZ goes to 57. Is there an advantage to holding the spread until expiration if I want to be called out anyway? When might there be an advantage to waiting for expiration?

2. If I have a debit spread and hope to be called out, is there ever a time that one is not called out even though the strike is below the underlying? I have a debit spread February 50-February 55. XYZ is 56 at expiration. My long is sold but my short is not bought. That would leave me naked. Is there a chance of this happening?

Jenyce Johnson

Jenyce,

That's a tough set of questions, so we called upon one of our resident experts, John Power of the Options Institute.

For the first part of your question, Power said that at least in terms of commissions, for a retail investor, it is usually a tossup as to whether to exercise or close out in the marketplace. The commissions are usually the same since the brokerage firm's work is much the same. So there is usually no commission reason to choose exercise/assignment over closing out the position in the market.

Most importantly for you, spreads (especially vertical spreads like in your example) do not usually reach their maximum potential value until they get very close to expiration (the last five to 10 days), unless they go very deep in the money.

Because of this, you would usually want to keep the spread position until expiration so that you could maximize profits. The maximum spread value would be (in the case of a vertical spread) the difference between the strike prices.

So, in your example, if the spread value reached almost 5 points, it might make sense to sell it in the marketplace before expiration (or assignment), says Power. If not, you have a judgment call as to whether you've made enough, so it's not worth waiting to expiration to get full value. (Also remember, the stock could move the other way before expiration and the spread's value could drop again.)

In a spread, you will control the exercise of the option you've bought; you will not control the assignment of the one you've sold. Therefore, no matter what you want, the process of being "called out" (I think the reader means assigned on the short-option position) is not under your control and may happen at any time. A large dividend (either cash or stock) can strongly influence people's decisions to exercise before expiration, so keep that in mind, Power says.

If you exercise your long calls before being assigned on your short calls, you will have the cost of buying and carrying the resulting stock position until your short-option position is assigned (who knows when?). This can wreak havoc with your profitability from the option strategy.

The bottom line, Power says, it is usually wiser to hold a spread position until close to expiration, as the position will usually not reach its maximum potential value until then. If, however, it goes deep-in-the-money earlier (or you are assigned earlier), you may have the luxury of choosing to close out the position in the options marketplace sooner.

The second part of the question: Is it possible to not be assigned (at expiration ) on an option which is in-the-money?

Yep, Power says, but it is usually unlikely. Equity options in a customer account that are at least 3/4 point in the money at expiration will be automatically exercised by the Options Clearing Corp. unless the customer gives written instructions to do otherwise. Index options of any value are automatically exercised, unless the customer directs otherwise.

Professionals, however, sometimes do not exercise options even though they might be in the money at expiration. Imagine in your example that the company in question, after the close of trading on expiration Friday, announces earnings severely lower than expected. Even though the stock closed at 56, there may be a good chance that the stock will open Monday morning well below 55. A trader who owns expiring 55 call options has a choice: Exercise the 55 call options she owns (and buy the stock at 55) or don't exercise and try to buy the shares on the opening Monday morning for less than 55.

That's the joy of options, according to our man Power: They give you choices.