LEAPing To Conclusions

There are plenty of ways to try and reduce your cash exposure, but some are better than others.
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Steve,

I am a long time subscriber to RealMoney. I've read your article How to Boost Returns Using Options , and found it to be very helpful. But I couldn't find any articles on RealMoney explaining how one can use options to replicate positions in one or more index funds, reducing cash exposed to the market, but maintaining the same overall return. A long time ago, I decided to use Proshares Ultrashort QQQ (QID) - Get Report to keep my market exposure, but reduce the amount of money I had in the market. So I only have 50% of my money invested in the market. I am looking at ways to reduce that further and was hoping you had an article somewhere that illustrates how this can be done via options. I have seen some strategies that used LEAPS to do this, but I need more info. Thanks, Vasso.

For starters, simply buying options on the index will drastically reduce your cost or capital requirement. For example, buying calls on the Proshares Ultrashort QQQ or any other exchange-traded fund, such as the

Spyder Trust

(SPY) - Get Report

is going to have a lower margin requirement. It equals the cost of the calls, and the risk is limited to the cost of those calls.

I

discussed this in an article a few weeks back.

Both of these instruments provide unlimited profit potential and the leverage of options to help boost returns. Of course, this cuts both ways, as a 5% decline in a stock or ETF can translate into a 30%+ loss in the option position.

The reader is right to hone in on using LEAPs, or Long-term Equity AnticiPation Securities, as an alternative to trading the underlying shares.

Here are a pair of articles on LEAPs, the

first discusses how LEAPs differ from and can be alternatives to trading the underlying shares,

the other ways they can help lock in profits and reduce risk.

On the first issue, understand that LEAPs are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years.

A key advantage for LEAPs: They don't experience significant time decay if more than a year remains in the life of the contract. Typically, the decay curve's slope becomes noticeable with about eight months remaining and accelerates steeply as expiration approaches.

Also, LEAPs can mimic the behavior of underlying shares because they have such long life spans (that is, a long time before they expire), the at-the-money strikes tend to have fairly high deltas and, therefore, closely track the price of the underlying shares of stock.

This can make LEAPs a great alternative for an investor who expects significant long-term growth in an underlying stock, but doesn't want to make the substantial capital outlay required for entering a long-term position in the stock. Remember, each LEAP contract, like standard equity options, represents 100 shares of the underlying security, providing tremendous leverage.

There is, however, a potential drawback to buying LEAPS instead of the stock: Owners of LEAPs or any options do not qualify for receiving dividends. As more companies move toward paying dividends and as favorable tax rulings are phased in, this may be an important consideration for investors hoping for a steady yield from their portfolio.

One way to boost the return is to use LEAPs to create a covered-call position. To do so, you buy the long-dated option and sell a nearer-term call with a higher strike price, typically 5% higher than the LEAP you own, or two strikes out-of-the money. This will allow you to collect short-term premium income through the accelerated time decay of the near-term option sold short and reduces overall cost of the LEAP.

On the second front, the main thesis involves how to create a collar. To briefly summarize the advantage of using LEAPs for collars is that they can provide greatly reduced risk while still allowing for upside profit potential. Because stocks have an upward bias, most option-pricing models (Black-Scholes, for example) will award a long-term out-of-the-money call at a greater value than the corresponding put.

This creates a situation in which the higher the volatility and the longer the time horizon, the greater the difference in the strike prices in which the call and the put will have the same price.

Assume, for example, that XYZ is trading at $100 and has an implied volatility of 50%. Its January 2006 at-the-money put ($100 strike) would have a theoretical value of about $23, while the January 2006 $110 call would be priced at $24, even though it is $10 out of the money.

This creates a no-cost collar that eliminates all downside risk (your minimum sale price is $100), while maintaining the potential for another of 10% profit if XYZ goes above $110 per share.

Note that because the potential gain of just 10% over an 18-month period may not seem appealing for establishing a new position, the more likely application would be to collar an existing stock holding that has substantial but unrealized gains.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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