clappy
I present here a long post of a little article I wrote in January. I don't pretend that it serves as a "do all, for all" but it works very well and this methodology has made me some very good returns (10-25% per month).
As an aside, since about 85% of all options expire worthless every month - which would you rather do, buy or sell?
Paper trading is a great(and protective) way to learn this stuff!
Good trading
HJ
Copyright© 2000, Harry L.S. Jones
LEAPS and the MAGIC NUMBER
First of all, I want to thank all of the instructors, Bob, Ryan, Kevin, Darlene and others un-named, as well as, of course, Wade who have contributed to my understanding of these positions.
Before reading this article you should all understand that “I’m not normal”. That’s a quote from Ryan at my second Next Step.
He’s right. I view things a little differently than most traders. This article may attack the problem of deciding on a good trade in a way you have not considered before. I suggest that it is a reasonable, and profitable, method of making trade decisions.
Let’s use a snap shot of Intel for purposes of illustration. The figures are real. I’ll even go so far as to tell you dates and times if you want to check them out. It’s not really necessary though. I’ve checked this about twenty times in the last three days and, even though the underlying stock has been all over the place, this method still works.
On Friday, January 7, 2000, right after market open, INTC was trading at $79 ¼ ask. The 2002 JAN 30 LEAPS options were trading at $53 ¾ x $54 ¼.
OK, Here’s the way I look at this position.
If I buy the 02-30s at $54 ¼, then exercise the option, my basis in the stock would be $84 ¼, the $54 ¼ cost of the LEAPS option plus the $30 price I pay to exercise. I call this my “MAGIC NUMBER”. You’ll see why in a minute. Basis just doesn’t do it justice.
Here’s my first test.
What am I really paying for the time element of my option? In this case $5, $84 ¼ (MAGIC NUMBER) – 79 ¼ (ask on the stock). Do I think Intel has any possibility at all of going up $5 in the next 24 months, remember this is a play on the 02 LEAPS option?
There are two lessons in this first point.
One is to pick the right stocks for this play. Upward moving companies with a history of splits and strong presence in the market, with LEAPS options available DEEP in the money and out at least 1 ½ years, more if you can get them. Well, I think Intel fits this definition!
The second point here is, how much of a move do I need to be safe, i.e. no loss. I think Intel fills the bill here too. It’s only my opinion but I think the chance that Intel won’t go up $5 in the next two years are slim and none (might split one or two times too)!
Second test.
I divide my total cost over the entire 24-month life of this LEAPS option to find out what it costs me to own this LEAPS option per month. In this case $5/24months yields 20.8 cents per month.
If this number is below $0.50 I look real hard. If it’s below $0.25, look out, get out of my way!
Now here’s the test – can I sell calls every month on Intel, two or three strikes out of the money, front month, covered by my LEAPS option, for at least 21 cents?
I can answer this one with a scream – YOU BET! (check historical quotes on INTL options)
So what have we accomplished so far?
Our planned trade passed the first test and we think the second test.
Let’s go check the current options to see if we’re right.
Our magic number is $ 84 ¼, right? That means to make sure we don’t get hurt we must sell the 85s or better. If we check the 85s we find that the Jan85 option with exactly 2 weeks to go to expiration can be sold for $ 1.25. That’s the low for the day and if I remember correctly we buy on dips and don’t necessarily want to sell our calls right away – but – but - since that MAGIC NUMBER is $ 84 ¼, we could even sell now and make a profit! What about the 90s, two weeks to go and we could sell for $.625 and pick up a capital gain of $ 5 ¾ if we get called out.
Two weeks. Hit me with a brick! I like it.
There’s still more good news. Check this out.
It costs $ 0.21 to own this LEAPS option for one month – right? Well, If we sell the JAN90s at $0.625 the return on our investment, on a monthly basis, is 594% ( 0.625 we took in divided by our .21 cost for the month and remember this was for 2 weeks, ½ a month).
Did I like it before? WHAT ABOUT NOW?
But wait, it still gets better.
Remember we bought into this deal on a dip and we might wait to sell the calls. On Tuesday, January 11, 2000, the Jan100s went for a low of $1.25 since the stock went back up. That’s double the monthly return we were talking about 2 days ago on the JAN90s, plus think about what the capital gain would be if you got called out at $100 in two weeks.
That number really is MAGIC because it can mean so much and give you a quick easy way to narrow down your candidates to a very manageable few.
I suggest you run this scenario on a number of stocks to see how it works. Try INTC, MSFT, DAL, GE, CSCO, DELL, AMTD, EMC, and others.
One parting thing to think about – you don’t really want to get called out, you want to hold the LEAPS option on this company for future appreciation and possible splits (remember how we picked this candidate in the first place), so you really do want to sell the covered call at the higher strike price.
Now go back and re-read this little article three or four times. It may take that long to really soak in.
Once it does, I think you’ll like it.
Good Trading
Copyright© 2000, Harry L.S. Jones |
