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How do you all use Leaps?


Myth465
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I am looking at event driven value investing if there is such a thing, and am really digging into Leaps and longer data options (maybe 8 months).

 

How do you all use them? So far so good, my only issue is do I stay near the money, deep in the money, or out of the money. I am a pessimist by nature so even if I think something is worth $60 and its trading at $20. I want to make money if it hits $25 - $30. This usually leaves me slightly out of the money on 2 year leaps.

 

Am I missing something or leaving alot of cash on the table buy not going a bit further out on the risk curve.

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Leaps are just leverage/margin with a different name.  Even worse, you are buying a long dated put on a stock that you probably think has little downside 2-3 years out. 

 

Put another way, the only reason to ever buy a leap is if you want leverage (and can't get it through margin) and think there is a serious risk to the downside 2-3 years out.  If there isn't a serious risk to the downside (that isn't priced into the leap, ie, where the leap isn't very expensive as a result of an obvious binary business risk that is coming) there is absolutely no reason to ever buy a leap.

 

 

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Yes, you know exactly what you will lose when you buy a leap.  However, risk can be defined in many ways. 

 

Let me give you a crude example:

 

MSFT is currently a value investor favorite.  Cheap, low leverage, etc.  The stock is $28.  Jan 30, 2013 Leaps are $3.40

 

It would seem like this is a fantastic bargain.  I mean, Microsoft won't be $33.40 in 2 years?  Further, if its $37, I'd double my money on the leaps versus only making 30% if I bought the common.  Why not do it?

 

The problem is you are paying for leverage and a "put" in Microsoft.  The fact that you only can lose what you put up is why you are paying for a put.  If you don't think Microsoft has much/any downside come Jan 2013 from today's $28 price (I don't) why would you buy this put?  You'd be better using margin or not using options at all. 

 

My point is options/leaps are mostly a hidden form of leverage with an implied put involved.  They have their purpose, but only when you are very concerned about downside in a stock - not just because you want to put leverage in your portfolio.

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Put another way, the only reason to ever buy a leap is if you want leverage (and can't get it through margin) and think there is a serious risk to the downside 2-3 years out.  If there isn't a serious risk to the downside (that isn't priced into the leap, ie, where the leap isn't very expensive as a result of an obvious binary business risk that is coming) there is absolutely no reason to ever buy a leap.

 

I would have to disagree with you on this point.  Although (I believe) leaps should only be used sparingly, there are a number of reasons to buy them.  First of all, they could simply be mispriced.  Buying a dollar for .50 is always the way to go, as long as you know that it isn't counterfeit, you are not passing up a .30 dollar, and your total risk profile is okay.

 

The specific question on this topic is buying on an event.  A binary event does not necessarily have to have a downside to make the leap useful.  The math works the same without the downside. Note that your portfolio has to structured correctly for your actual risk and for the margin requirements, if you want leverage. (Personally, I would not buy a leap without a catalyst, but a few people on this board bought the mispriced FFH options when they were being dumped by the short sellers.  For me the problem without an event type catalyst is that you could be right about the company but wrong on the timing.)

 

I also find it interesting that you call the limited downside on leaps a put.  That is an interesting way to conceptualize it.

 

happy investing in 2011

 

Netnet

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I have posted this other times...

 

I use Leaps when I would like to buy the stock as a value investment - as a more profitable proxy.  For two years now I have held GE Leaps.  The first ones were 2010 and 2011s coming out of the 2008 crash.  I rolled those over into 2012s and now 2013s.  In aggregate I have made far more than I have lost and far more than if I had just bought the stock. 

 

I have also used them for SBUX, HD, WFC, AXP, SPY units, FFH, and MFC.  The only one where I lost my shirt - so to speak - about 10000 was MFC.  They trade only in Canada and are very illiquid.  That is a learning experience.  Stay with highly liquid positions which means big international markets. 

 

If a stock meets my purchase criteria then I will look into the Leap action, not the other way around. 

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I dont see any obvious contenders right now for Leaps among the large caps.  Maybe RBS but I haven't spent enough time on the financials.  I still hold a few preferreds from nearly two years discussed in the Preffered thread.

 

WFC and BAC can be levered through the Warrants rathered than leaps although both are way up from my purchase price in the fall.

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I have posted this other times...

 

I use Leaps when I would like to buy the stock as a value investment - as a more profitable proxy.  For two years now I have held GE Leaps.  The first ones were 2010 and 2011s coming out of the 2008 crash.  I rolled those over into 2012s and now 2013s.  In aggregate I have made far more than I have lost and far more than if I had just bought the stock.  

 

I have also used them for SBUX, HD, WFC, AXP, SPY units, FFH, and MFC.  The only one where I lost my shirt - so to speak - about 10000 was MFC.  They trade only in Canada and are very illiquid.  That is a learning experience.  Stay with highly liquid positions which means big international markets.  

 

If a stock meets my purchase criteria then I will look into the Leap action, not the other way around.  

 

Thanks Uccmal.

 

This is how I use them. As cheap leverage, or when I have a catalyst (Deep Water Horizon being the best example).

 

What do you think of Leaps with High Yield?

 

I notice when a stock is high yield the leaps trade with no premium. One can buy them and make an extreme amount of money with a relatively small movement. SSW and options on many of the MLPs a year or so ago would have worked well, and my guess is leaps on FTR will work extremely well. The stock is at $9.6 and should it trade to $12 by 2013, I will double my money. The yield is 8%. I think it will move down to 5% should the low interest rate environment persist for much longer.

 

----

 

I am getting more and more excited about them, and have also noticed that they allow me to hold alot more cash and not give up so much in the way of return. One can also trade down on them during a selloff and not have to worry about a wash sale due to buying different strike points. I see many advantages to stocks, and only 1 disadvantage - you have to get timing right, or buy a cheap enough leap that it doesnt matter.

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By definition, a leap is leverage + an implied put.  That's it. 

 

Right now leaps are cheap because vol is low (risk is low) and borrowing costs are almost 0. 

 

If you wouldn't want to own a put on the stock, there is no reason to own a leap.  Yes, of course it depends on the price of the leap!  I figured that goes without saying.  But for you to say that the leap is mispriced or cheap, then you are specifically saying the implied vol is cheap and that the market isn't pricing in the risk to the downside appropriately.  But, if you think MSFT is worth $40 and its trading at 25 and a 25 leap is $5 - that doesn't make the leap "cheap" or mispriced.  It means you think MSFT is mispriced and you want leverage to take advantage of the modest move from 25 to 40 without risking a ton of capital (the implied put). 

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I dont quite follow your put reference. For me a leap is cheap if the premium is extremely low or there is a known catalyst to send the stock up. I dont believe black scholes pricing is correct so there valuation doesnt matter to me.

 

Ok, I will explain.  Owning a call is exactly the same thing as owning a stock + owning a put.  It's mathematically the same thing and it costs the same thing.  It's called put/call parity. 

 

The only reason a leap would have extremely low premiums would be if the price for puts were also very inexpensive, ie, vol is very low and people do not expect a large move either way, especially to the downside.  If you expect a large move than you would want to buy vol and thus buying a leap would be beneficial. 

 

Now, buying leaps on MSFT or GE or whatever is really just someone wanting an extreme amount of leverage with a maximum downside.  Mathematically, assuming interest rates/borrowing is 0 (margin rates are almost that low), the following two things are identical:

 

(making up numbers)

 

MSFT is $25.  MSFT Jan 2014 Leap is $5, strike $25.  MSFT Jan 2014 put is $5, strike is $5.  (this is only the case if interest rates 0 and MSFT pays no dividend, otherwise put and call prices would be different). 

 

You can buy 1 share of MSFT at $25 and 1 put for $5 and you max loss is $5 and your breakeven is $30.

You can buy 1 Leap for $5 and max loss is $5 and your breakeven is $30. 

 

In the former example, you put up $25.  In the latter, you put up $5.  If you couldn't/didn't want to use margin, you could buy 5x as much MSFT with buying the LEAPS vs buying MSFT at $25 and $5 puts.  But make no mistake about it, it's pure leverage w/ an implied put. 

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I should say,it gets more complicated with deep out of the money calls and/or call spreads.  But it's still just a form of leverage and an implied put.

 

The most strategic way to use options/leaps is when you have a very good view of what the maximum upside/downside is in a situation and you know the timeline well. 

 

I own TIVO May 15/17.5 call spreads I paid about 35 cents for.  I own these because by May, there will be a verdict in their trial against DISH.  If they win, the stock is 100% going to go to at least 17.5 (based on where it went the last time they got a positive verdict only to have it overturned).  If they lose, it will plummet - hard to say where - maybe $5?  By paying 35 cents for a $2.5 outcome, the market was only pricing in a 14% chance TIVO wins the hearing while I think it's at least a 50% chance.  I believe the option market was not pricing in the deep out of the money calls correctly.  Ironically, someone today bought 20,000 May call spreads on TIVO but higher strikes (the 17.5/20 spread) and paid 32 cents. 

 

So in my head I figured 50% chance TIVO goes to $5, 50% chance it goes to 18+.  Stock is $9 today.  What's the best way to play this?  And I came up with the deep out of the money call spread. 

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The only reason a leap would have extremely low premiums would be if the price for puts were also very inexpensive, ie, vol is very low and people do not expect a large move either way, especially to the downside.

 

 

This isn't always true.  The cost of being synthetically short versus being synthetically long is sometimes affected by the borrowing costs of a security (when it is heavily shorted).

 

Take SHLD a year ago for example -- you could write  a put at-the-money and with the proceeds you could buy two calls at-the-money.

 

Totally out of whack.  Write a put for 1x downside and buy a call for 2x upside.  This exact scenario was brought to the attention of this board at the time.  The world is full of surprises I suppose.

 

 

 

 

 

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The only reason a leap would have extremely low premiums would be if the price for puts were also very inexpensive, ie, vol is very low and people do not expect a large move either way, especially to the downside.

 

 

This isn't always true.  The cost of being synthetically short versus being synthetically long is sometimes affected by the borrowing costs of a security (when it is heavily shorted).

 

Take SHLD a year ago for example -- you could write  a put at-the-money and with the proceeds you could buy two calls at-the-money.

 

Totally out of whack.  Write a put for 1x downside and buy a call for 2x upside.  This exact scenario was brought to the attention of this board at the time.  The world is full of surprises I suppose.

 

 

 

 

You are absolutely right.  But in that case, if you were long the stock, you could get paid to lend it out.  If you aren't able to lend stock out then yes, any time a stock is heavily shorted with a very high negative rebate you should always buy it through options (buying a call/selling a put same strike) to take advantage of this.  

 

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