Chapter 8

Strategies in Volatile Markets: Uncertainty as an Advantage

The market doesn’t reward qualities that are not scarce.

—Mark A. Johnson, The Random Walk and Beyond, 1988

 

 

 

Volatility—the feature that stockholders are most concerned with—may serve as a big advantage to options traders. Stockholders like steadily rising markets because that makes profits. If you are like so many first-time investors, you probably began your investment program during bull markets; unfortunately, markets are cyclical and those uptrends can and do turn suddenly.

If you are a more experienced investor, you understand that success has to be defined in terms other than the absolute of winning or losing. You know that being right more often than wrong defines investing success. You also know how to diversify and limit risk even in a rising market, and you understand the old wisdom that stocks climb a wall of worry.

Smart Investor Tip

Success in the market may be defined as being right more often than being wrong. Expecting loss is realistic; if a loss takes you by surprise, then you need to take a second look at your expectations.

Hindsight always clarifies observations of upward and downward trends. When we look back, the signals appear obvious, as though they could have been anticipated easily. However, it is far more difficult to identify the type of market we are experiencing at this moment, and what is going to happen next. At any given time, some observers think the market is rising, others think it is falling, and a third group adopts a wait-and-see approach. Each of these groups can cite plenty of market data to support their points of view, but they cannot all be right. Your dilemma in this environment of uncertainty is finding a way to build your portfolio of stocks while also minimizing your risk of catastrophic losses. You want to take advantage of emerging rises in the price of stocks and, at the same time, limit your risk exposure. You may be tempted to flee the market in times of uncertainty, understandably. But fleeing is not the only prudent decision. You can also employ options in volatile markets to take advantage of that volatility, and to improve profits while protecting yourself against unexpected losses.

Avoiding 10 Common Mistakes

As a starting point in defining your market strategy, examine the basic assumptions that go into how and why you have made past decisions. How do you pick a company? Do you study its fundamentals, follow price chart patterns, or buy stocks on the basis of name recognition?

Smart Investor Tip

Your methods for picking stocks should be carefully and completely defined. Otherwise, it is easy to fall into the trap of picking stocks on the wrong assumptions: by past profits, name recognition, or rumors.

Some common errors characterize the way that some investment decisions are made. These include the following 10 mistakes:

1. Failing to follow your own rules. Many people define themselves as believers in the fundamentals, and then contradict their own standards. Instead of monitoring trends in the important areas of statements, they find themselves tracking stock charts or making decisions based on index movements.

The market is full of temptations, promises of easy money, and artificial excitement. But it is also a dangerous place. With the benefit of history, it is easy for you to recognize the real situation at any given time. However, in the heat of the moment, many investors give way to an emotional response to information. If you hear a stock is about to “take off,” the human tendency is to want to buy some before that happens. A logical, rational approach would tell you otherwise. If the person giving you this tip does actually have insider information, it is illegal to pass that information on to others—and it is illegal for others to act on the information. If the person does not have insider information, then it could be only a rumor, in which case you should not act on the information. It could also be a pump-and-dump move. This occurs when someone owns a stock whose price has fallen. They want to get the price up so they can sell their shares at a profit, so they promote (pump) the company, get others to buy, and then they sell (dump) inflated shares.

2. Forgetting your risk tolerance limits. More than anything else, continually examine and reexamine your limitations. Risk tolerance means just that: the amount of risk you can afford to take and are willing to take. If you cannot afford to lose, then you should not expose yourself to a high risk of loss.

Identifying risk tolerance levels should be thought of as the first step in beginning an investment program. When someone buys their first house, they identify how expensive a home they can afford, the level of down payment required, market trends, and other important factors. This is all part of risk tolerance. However, the same people may enter the market with little or no thought to the level of risk. Unfortunately, this approach has consequences. If you cannot afford to lose money, you need to question whether a particular strategy is appropriate. This applies not only to trading in options, but to every market and strategy. Knowing your risk tolerance is essential.

insider information

any information about a company not known to the general public, but known only to people working in the company, or with nonpublic knowledge about matters that will affect a stock’s price.

pump and dump

action by an individual holding shares of a company. It involves spreading false rumors in order to get people to buy shares and increase the price of stock, and then selling shares at a profit.

risk tolerance

the amount of risk that an investor is able and willing to take.

3. Trying to make up for past losses with aggressive market decisions. Losses can happen very suddenly, or they can accumulate over time, eroding your portfolio value. In either case, losses represent ill-timed decisions. Avoid the tendency to try to make up for big losses by taking unacceptable risks.

The reason it is so important to identify your risk tolerance is to avoid making big mistakes when your decisions don’t go the way you planned. Many investors try to offset unexpected losses by taking ever-higher risks in the hope of getting their losses back. When those investor begin this practice, they cease being investors and become gamblers. And most gamblers lose. It makes more sense to accept losses as part of the outcome within your portfolio, learn from those losses, and take steps to decrease losses in the future. Those steps can include better stock selection, protective measures (including the use of options, for example), and diversification.

4. Investing on the basis of rumor or questionable advice. The Internet chat room is not a good place to get market information. Unsolicited phone calls, pop-up advertisements, or mail solicitations for investment solutions, promising fast and easy profits, are not going to make anyone rich. Advice from friends, relatives, coworkers, or people you talk to on the bus or train should be discarded.

If you are intent on getting advice from someone else, think carefully before you pay for that advice. The history of analytical services offered by the big brokerage firms has been quite poor. Not only have these firms given historically poor advice; it would often have been more profitable to do the exact opposite. The big firms have also been fined millions of dollars for knowingly giving poor advice to clients. With today’s Internet-based market, a lot of free advice is available from many different places. You can also act based on advice from friends, relatives or coworkers. But the truth is, no one is going to give you free good advice. Making smart investment decisions invariably requires that you perform your own research, apply your own standards based on clearly identified risk standards, and do your homework directly.

mutual funds

investment programs in which money from a large pool of investors is placed under professional management. For a fee, management invests in stocks and bonds. Mutual funds may be set up to pay a sales load to salespeople, often called financial advisers; or they may be no-load, meaning investors can buy shares directly and not pay commissions.

5. Trusting the wrong people with your money. As a group, analysts’ advice has led to net losses for their clients. The problem is not limited to analysts’ conflicts of interest. As a group, analysts tend to pick earnings and price targets rather than try to find solid fundamental strength in companies. This makes analysts a poor source for market information; you are better off on your own. If you do intend to hire someone to advise you, make sure they base their investment advice on sound fundamentals. If you check, you will discover that the majority of financial advisers and analysts know little or nothing about accounting standards and rules and do not base decisions on tried-and-true fundamental principles. It is more likely that a financial adviser will try to steer you into mutual funds rather than stocks because funds pay more than 8 percent commission to salespeople; and, of course, investors pay this through a sales load. For example, if commission is 8.25 percent, that means that out of every $100 you invest, only $91.75 goes into the investment; the rest goes to the salesperson (financial adviser). You do not need to pay commissions to find sound investments; and by definition, anyone buying stocks and trading options should be making their own decisions and not relying on expensive advice.

sales loa

a commission charged when a financial adviser places a client’s capital into a load mutual fund.

6. Adopting beliefs that simply are not true about the markets. The market thrives on beliefs that, although strongly held, are simply not true. Widespread beliefs are difficult to overcome, but it is wise to question convention, especially when you see time and again that those beliefs are invariably misleading.

For example, many investors insist on believing that there are secret, magic formulas that guarantee success in the stock market. Even though the facts clearly dispute this belief, thousands of people send away money every year to learn these “insider secrets” to market wealth. You will never meet anyone who has become rich in the market by following any formula that they paid to find out about.

7. Becoming inflexible even when conditions have changed. You may find a method that works for you, so you stick with it, even when conditions have changed and the strategies are no longer working. You need to maintain your flexibility, because markets are in a continual state of change.

The market is constantly evolving and changing. Very little remains true for long, so even today’s favorite stock or market sector could easily be out of favor next month. You only need to look back over history to realize how easily an industry can become obsolete. Before 1900, auto and airline stocks did not exist, and before 2000, digital cameras were not widely known, so companies such as Polaroid and Kodak dominated the film markets. A review of the fundamentals for any company out of favor today reveals falling stock prices, lower profits, and a relentless decline in all of the fundamental indicators. There are good lessons to be learned from history, and the market reflects change as a constant element.

8. Taking profits at the wrong time. The temptation to take profits when available is a strong one. However, the timing of profit taking should depend more on your overall strategy than on a momentary opportunity. If you always take profits when available, you will end up with a portfolio full of stocks whose current market value is lower than your original cost.

Using options as a secondary strategy in your stock portfolio enables you to take profits without needing to sell stock. This can be accomplished in several ways. For example, when stock values climb high, you can sell covered calls or buy puts. If and when market values fall back to previous levels, the short call or long put positions can be closed at a profit—but you continue to hold your long-term stock. When stock values fall, you can also take advantage of the temporary panic, by buying calls (you can also sell puts in this situation, a topic covered in the next chapter). When the stock price rises back to previous levels, the option positions can be closed at a profit.

9. Selling low and buying high. The advice to buy low and sell high is easily given but harder to follow. It is all too easy to make investment decisions on the basis of panic (at the bottom) or greed (at the top). A worthwhile piece of market wisdom states that bulls and bears are often overruled by pigs and chickens.

It is not easy to resist the emotions of greed and panic; but you need to think long term when you invest in stock. If you select companies based on sound criteria, you do not need to be concerned about short-term price movement, not to mention rumor and speculation about what will happen tomorrow. Options can also be useful in overcoming the paradoxical temptation of long-term investors, which is to act like short-term speculators and against their own best interests. Options are excellent instruments for hedging other positions, riding short-term price movement, and taking profits, all without having to sell stock before you really want to (on the upside) or because prices fall temporarily (on the downside).

contrarian

an investor who recognizes the tendency for the majority to be wrong more often than right, who invests opposite popular opinion.

10. Following the trend instead of thinking independently . Crowd mentality is most likely to be wrong. Crowds don’t think; they react. So mistakes are likely to occur when you follow the crowd instead of thinking for yourself.

Successful investors learn to think for themselves and to avoid crowd thinking. This means not only resisting the temptation to follow the majority, but also to recognize that the majority is usually wrong. This contrarian approach to investing has proven to be successful historically because crowd mentality is a misguided way to think.

Modifying Your Risk Tolerance

Recognizing common mistakes in approaches to investing is a good starting point in determining how not to approach stock and options investing. All of the mistakes involve perceptions or misperceptions about the markets, but they all share a common element: a perception about risk. If you can identify risk levels to a particular strategy and quickly decide whether they are good matches for your own risk tolerance, you will be far ahead of most other investors and traders. Risk exposure is the central determining test for every investing strategy you will consider.

Your ability and willingness to be exposed to risk is a matter of degree. Risk tolerance is defined by capital resources and income, investing experience, family status, condition of the market, and your personal attitude. It is ever changing because as your own circumstances evolve, all of these areas evolve as well.

Smart Investor Tip

Risk tolerance is an ever-changing matter, reflecting your attitude, experience, knowledge, and resources at the moment. It will be different next year and the year after, so you need to review risk tolerance constantly.

Capital resources and income define your ability to undertake certain risks. If you have a large amount of capital to invest, you will be able to consider a wider array of possible investments than if your assets are more limited. Of course, that also means that you will likely be unaware of the risks associated with some decisions. Having a large amount of capital available might contain risk of its own in that regard; so if you inherit a large sum of money, sell your house, or take other actions that bring you a large nest egg to invest, you need to still pay attention to risk. The same arguments apply to income levels. An individual with a comfortable level of income will be more inclined to diversify in terms of investment products and risks. As a strategy, it makes sense to vary the risk levels of your portfolio as long as it is part of a plan. The danger arises when risks come about unexpectedly.

Investing experience has a lot to do with the risks you take on and how you evolve as an investor. As you become familiar with options, for example, you will be willing to try advanced strategies, use options in different ways within your portfolio, and diversify risks with option positions. Experience has another side: those who have lost money in the market learn about risk the expensive way. Many people walk away from the market permanently, which is a risk decision. They conclude that the market is simply not a safe investing environment. In fact, it can be, if you learn how to mitigate specific risks.

Family status has a lot to do with the types of investments you choose. If you are a young single person making good money, you will be inclined to take greater risks; if you are married, buying a home, and raising young children, you will by necessity think about security, college education expenses, and retirement savings. Major events, like marriage, birth of a child, divorce, losing a job or starting a new career, relocating, health problems, or the death of a loved one, will understandably have a major impact on how you invest, because such events change your risk tolerance profile.

Condition of the market will also change your risk tolerance. When the market is going through a broad-based bull period, it is easy to feel confident about investing. As a result, there is a tendency to lower your observation. In these conditions, it makes sense to buy and hold securities as long as the good times last; but at the same time, be aware of risks. Markets can turn around quickly.

Smart Investor Tip

Even recognizing the fact that markets change continually, it is easy to make the mistake of fixing your definition of risk and never changing. As a consequence, your profile can become outdated.

Personal attitude will have more to do than anything else with your definition of risk tolerance. If you consider yourself ultraconservative, you will prefer to leave the majority of your portfolio in low-yielding, insured money market accounts. Others can tolerate high risk and seek the best possible returns and will speculate in long-shot investments. Most people are somewhere in between.

The Nature of Market Volatility

Risk comes in many forms and, as a result, your definition of risk tolerance has to take the different forms of risk into account. A study of price volatility is a good place to start. Volatility can and should be applied to individual issues. This does not mean that overall volatility trends should be ignored; however, because listed options are specific to a single stock, the study of volatility can be used to measure risk, to identify market conditions, and to find option opportunities.

Market volatility follows cyclical patterns just as prices do. When prices for specific stocks, sectors, or the overall market rise rapidly, we usually also see increases in the volume of shares traded. A short-term rally is characterized by a corresponding short-term volatility, meaning prices can change in both high and low directions within a single day or week. A longer-term rally—lasting several weeks, for example—will tend to be broader based. Market volatility will slow down as the rally begins to lose its momentum, which is one way to identify the top of the market—not always, but often.

Being aware of the patterns and tendencies of market volatility does not necessarily provide you with a key to the timing of option decisions. In fact, in the most volatile of markets, it is the uncertainty of the timing of events that makes the market the most interesting, and the most dangerous.

Smart Investor Tip

Volatility introduces both risk and opportunity. The very uncertainty associated with big price swings provides options traders with the best environment for profits—if properly understood.

Volatility is an expression of conflicting investor interests converging at the same moment. A high demand or a high supply resulting from greater-than-usual volume has an immediate effect on stock share prices and on option premium levels. When time value is distorted during high volume periods, it creates a momentary advantage for options traders. Distortions occur most often during highly volatile periods for a specific stock, but the offsetting market reaction tends to correct the condition within the same trading day. So to take advantage of time value price distortions, you will need to track the market throughout the day.

Smart Investor Tip

Options traders who plan to take advantage of short-term price aberrations have to be prepared to track prices closely, and to act quickly.

Market Volatility Risk

Understanding the nature of volatility is essential. When you use options to accompany open stock positions, you eventually realize that volatility is going to affect your equity position, and is not just a short-term profit opportunity in options. The risk feature of volatility is going to determine the safety of your portfolio.

This danger—market volatility risk—is especially important if you write covered calls. Selecting stocks for long-term growth as the primary means for finding investment candidates is a fundamental strategy. However, picking stocks primarily based on the richness of option premium levels is a shortsighted strategy that may lead to losses. There is no sense in exchanging short-term option profits for losses in stock value. Richer option premiums are associated with more volatile stocks. The higher premium levels exist because the stock itself is higher risk.

This is a trap for options traders. When you think about buying stock without considering the related options, you will tend to look at financial information, long-term competitive stance, the sector, management, dividend yield, and price history, among other indicators. However, when you are looking for covered call writing opportunities, it is tempting to buy 100 shares and sell an option at the same time, using the discounting effect (return from the option) as your primary consideration. If you ignore other risk elements of the stock, you invite greater risk. The more volatile stock is, the more likely it will be to lose market value in a market decline.

Smart Investor Tip

Beware the tempting rates of return available from buying stock and selling covered calls at the same time. Don’t overlook the importance of analyzing the stock as a starting point, not as a subordinate point to the option’s value.

The question should be, does the option discount the share price adequately to justify the higher risk? If the option profit only serves to equalize the market risk of the stock, are there more sensible alternatives? It makes more sense to purchase the stock of less volatile companies and wait out price movement, and then sell covered calls with striking prices well above your purchase price, ensuring higher profits even in the event of exercise. While this strategy is more conservative and requires time to build profits, it also avoids the problems of market volatility. Because the federal tax rules affecting capital gains also affect after-tax profits, it makes more sense to sell out-of-the-money calls than in-the-money calls, or to accept short-term gains in exchange for higher premium income.

fundamental volatility

the tendency for a company’s sales and profits to change from one period to the next, with more erratic change representing higher volatility.

The comparative analysis of market volatility emphasizes a stock’s share price and trading range, which are technical indicators. An equally important form of volatility involves a study of trends in the financial results of the company. An analysis of fundamental volatility is a valuable method for picking stocks wisely.

Investors like predictability. You may take comfort when a company’s sales increase gradually and predictably from one year to the next, and when profits remain within an expected and predictable range. This preference has led to pressure on companies to equalize earnings through accounting decisions. You will also take comfort in the low volatility of financial reports, even when this results from creative accounting treatment of a less certain reality. You may feel safe with predictable outcomes, when fundamental volatility is low.

In the real world, however, sales and profits do not materialize consistently and steadily. Actual outcome is far more chaotic. How do companies even out their results, and isn’t that fraud? The generally accepted accounting principles (GAAP) rules give corporations a lot of flexibility to interpret and report their numbers.

The GAAP guidelines exist in no one place, but consist of a series of published opinions, guidelines, and regulations developed by many groups, with the American Institute of Certified Public Accountants (AICPA) serving as central authority for GAAP standards. The Financial Accounting Standards Board (FASB) develops new guidelines and also serves as a clearinghouse for rules within the auditing profession.

GAAP

acronym for generally accepted accounting principles, the rules by which auditing firms analyze operations, and by which corporations report their financial results.

Smart Investor Tip

Check the AICPA and FASB web sites to learn more about these organizations and the role they play in developing GAAP standards: www.aicpa.org and www.fasb.org.

GAAP rules are broad enough that corporations can bank earnings one year and recognize them in the next, so that the results are less volatile. This is called cookie jar accounting and, as long as the justification appears to make sense, it is allowed under GAAP. In fact, because earnings are being deferred, the bending of the rules is far more acceptable than the opposite—booking nonexistent revenues and hoping to absorb them in better sales periods of the future.

In the typical cookie jar entry, some of this year’s revenues, along with corresponding costs, are deferred and set up in a liability account. These are not true liabilities, just credit-balance accounts. So the deferred credit is reversed the following year and recognized as income. This is only one of many techniques used to reduce fundamental volatility. The existence of a deferred credit does not necessarily mean manipulation has taken place. In some instances, revenue is received in advance of being earned and it is appropriate to defer it; but the account is also used at times to control reported revenues and earnings.

cookie jar accounting

the practice of banking revenue or earnings in exceptionally high-volume years and booking them in later periods, to even out results consistently and to reduce fundamental volatility.

deferred credit

an account listed under the liabilities section of a balance sheet, representing income to be recognized in future years.

Inflating current results to improve an otherwise dismal operating result requires a different type of manipulation. For example, current-year expenses may be capitalized and then amortized over several years, increasing the current year’s profits. Depreciation can be spread out over a longer period than normal by making an election under Internal Revenue Code rules. Or reserves set up during acquisitions can be reversed to inflate current profits.

All of these types of entries might be allowed under GAAP; but whether accountants can justify questionable interpretations or not, the fact remains that these practices are deceptive. They give you a distorted and inaccurate picture of operations. If you make investment decisions based on inaccurate or unreliable information, you are being deceived. And to the extent that stock prices are distorted by misleading accounting decisions, option values are distorted as well.

Full disclosure and application of a universal reporting standard would be desirable. Full disclosure might also mean higher fundamental volatility. While this might be unsettling, it is always better to see an accurate result than to settle for the short-term comfort you gain from low fundamental volatility. Remember, higher volatility could have a positive effect on premium levels.

Smart Investor Tip

More accurate, consistent reporting probably would also mean greater fundamental volatility. Ironically, the more honest financial statements could reflect higher than average year-to-year volatility; this could require the market to change widely held opinions about the nature of volatility and risk.

Options in the Volatile Environment

The more uncertain a trading environment, the greater your concern for the safety of your capital. When prices are very low, you may be fearful about placing capital at risk, especially if you have already lost money in the market. At the same time, such moments are buying opportunities.

If you have cash to invest but you are concerned about market volatility, limited speculation could be a wise strategy. While buying calls is highly speculative due to the unavoidable expiration factor, the decision can work as an alternative strategy. Instead of putting all of your capital at risk in purchasing shares, you can buy calls as a method for controlling stock. If and when those shares climb in value, the calls can be exercised and you can purchase shares at the fixed striking price. But if stock prices decline, you are not obligated to exercise and you will lose only the money invested in call premium.

Considering that time works against the buyer, is it wise to buy calls as an alternative to simply buying stock? It can be. Using long-term equity anticipation security (LEAPS) calls with long-term life spans can make a lot of sense in volatile markets. Because LEAPS options last up to 36 months, they are more interesting than shorter-term listed options. In the market, 36 months is a very long time. If you select stocks that you believe have a better than average chance to appreciate in value, going long on LEAPS calls could be a profitable form of speculation.

When you buy long-term LEAPS calls, you will have to expect to pay extra premium for more time value. So LEAPS calls are going to be far more expensive than shorter-term calls; but with the time element in mind, the longer-term speculation can work to your advantage. There are ways to reduce the cost of long-term LEAPS positions as well. In Chapter 9, advanced strategies employing LEAPS calls are explained in detail. For example, you can purchase a call and then sell earlier-expiring calls with higher striking prices. This strategy reduces the cost of the long call. It is a relatively safe strategy, because the long position covers the short. Because you will have up to 36 months before the long LEAPS call expires, you can sell a series of short calls and allow them to expire during the holding period.

Another possible strategy for those who already own shares and want to acquire more is to sell a covered call and an uncovered put at the same time. (Selling puts is discussed in Chapter 9.) Using LEAPS options, this can create a substantial rate of return. So there are numerous LEAPS strategies, both long and short, that provide you with alternatives to the popular stock-specific strategies: dollar cost averaging, hold-and-wait strategies, profit taking, or simply getting out of the market. The use of options, especially longer-term LEAPS options, allows you to remain in the market and to create new opportunities with minimum risk.

Smart Investor Tip

LEAPS-based strategies can be tailored to match your risk tolerance. The big advantage with LEAPS is the extended time until expiration.

The problem of investing more capital in a down market is well known. Typically, when prices are down, there are numerous buying opportunities available; but it is also common for people to hesitate, fearing further declines. In this condition, it requires a cool head and calm nerves to go against the crowd mentality of the market, and to recognize the opportunity. Using LEAPS options, you can take advantage of depressed prices, without risking capital in long positions.

Example

Solving the Capital Problem: You have approximately $10,000 to invest. You have been following five stocks that you believe will increase in value over the next two to three years; but you cannot buy 100 shares of all of these with your limited capital. And because the market has been very volatile lately, you are not even sure that the timing is right for committing money right now. You don’t want to miss an opportunity, and you remain uncertain about short-term volatility.

In the circumstances just described, there are three problems: (1) limited capital, (2) uncertainty about short-term price volatility, and (3) the desire to profit from longer-term change. Everyone faces these conditions from time to time, and many face them continually. LEAPS options address all three concerns. With a $10,000 capital base as described, it is possible to buy calls for all five of the stocks. As long as options are picked out of the money, the premium cost will be lower than it would be for an in-the-money option on the same 100 shares. This diversifies the $10,000 capital into five different 100-share lots; but because these are options and not shares, the risk of loss is limited. The entire $10,000 could be lost if none of the stocks rises in value. But if they are selected well, that is a remote possibility at best. Three years is a very long time and in the cyclical market, today’s depressed conditions are likely to reverse and price will advance.

Smart Investor Tip

The LEAPS option removes the most inhibiting factor of the options market, the short-term nature of contracts and ever-looming expiration. A three-year life span is an eternity in the stock market.

Is it prudent to buy calls, given the risks of long positions as a general rule? It could make more sense than buying shorter-expiring standardized calls, which will expire in a few months. Remembers, a LEAPS contract has a life up to three years, and a lot can happen in that time. If you believe that stocks will rise in value during those months, then buying long-term options represents a smart strategic choice. If the market value does not rise, you lose the option premium. However, since you will be spreading a limited amount of capital among options on several different stocks, you stand a good chance of profiting overall as long as the market direction is upward during the lifetime of the LEAPS.

There are three possible outcomes in this strategy:

1. The LEAPS expires worthless. If the stock fails to rise above the LEAPS striking price, the strategy produces a loss.

2. The LEAPS increases in value and you close it at a profit. You might decide later on that you would rather take the option profit when available, and give up the opportunity to buy shares later.

3. The stock value rises and you exercise the LEAPS option, purchasing shares at the fixed striking price. This is the strategy to aim for; LEAPS are used to own the right to buy 100 shares at a fixed price, with the idea that you will want to make the purchase as long as fundamental conditions do not change.

LEAPS can be used in all of the ways that short-term options can be used. LEAPS calls can be bought to insure against losses in short stock positions; and LEAPS puts can be used to insure against losses in long stock positions. You can also sell LEAPS, either naked or covered. The covered call strategy will produce far higher premium income because of higher time value. In exchange, you will also be required to keep your stock tied up to cover the short option for a longer period of time. The typical time value pattern for LEAPS is that it remains fairly stable and then rapidly falls off during the last four to six months. Thus, covered call writing on very long-term periods should be analyzed and compared with shorter-term alternatives. When comparing likely rates of return, remember to annualize the outcomes to make them comparable; a 10 percent return on a one-year covered call is twice as profitable as a 15 percent return on a three-year covered call.

Smart Investor Tip

The risk/reward question for LEAPS covered call writers has to be analyzed carefully. The question of time is one aspect only, and the other aspect—exposure to exercise—is much longer term than for standard short-term options.

The potential uses of LEAPS beyond expected purchase (or sale) of shares in the future can become quite interesting. When you combine the longer expiration of LEAPS options with the features of shorter-term expirations, some of the typical trading techniques become more advantageous, especially on the short side. Remember, time works for the seller and against the buyer. As a seller of a LEAPS option, you are going to have more time value to work with and a longer time until expiration. As a buyer of a LEAPS option, you still work against time; but because expiration is so far away, the potential for profit—or at least the uncertainty of what will happen—makes buying options far more feasible.

The advantage of an extended time until expiration is partially offset by the LEAPS tendencies with extrinsic value, seen in variation in the LEAPS delta. When options are close to expiration, they tend to be very responsive to changes in the stock’s price. However, the farther out the LEAPS, the less responsive it is likely to be.

This reality often means the LEAPS premium changes very little even when the stock price moves many points. For example, if you own a LEAPS call and the underlying stock moves up three points, you might see only one point (or no points) of movement in a 24-month LEAPS call. What actually occurs in this situation is that extrinsic value falls as an offset against intrinsic value (assuming the call is in the money), or, if out of the money, the extrinsic value fails to react to price movement solely because of the long time period until expiration.

As frustrating as it is to see an unresponsive trend in a LEAPS position, it is an odd reality. In spite of the usual rules for interaction between intrinsic, extrinsic and time value, longer-term options are subject to these kinds of adjustments. So extrinsic value can act as an offset to changes in intrinsic value, or simply to hold down values of options due to the time itself. This does not mean that time value actually changes, but it does mean that the LEAPS will not act in the same, more predictable way that short-term options will act.

This can be an advantage, because the offset tendency works in both upward and downward movements. So if you are long on a LEAPS call contract and the stock declines, you are less likely to see a corresponding decline in the LEAPS call. Or if you own a LEAPS put and the underlying stock value rises, the offset can reduce the effect in the put value. Even with the offset experienced in extrinsic value, however, using LEAPS calls and puts in long positions can continue to make sense over the long term.

The same arguments favoring buying calls in anticipation of an upward-moving market apply just as well when you expect market values to fall. You can buy LEAPS puts when you have seen a big run-up in value and you anticipate a reversal. This strategy makes sense whether you own stock or not.

When you own shares and the market value has risen substantially, you face a dilemma. Do you take your profits now, while you can, and risk missing out on even more appreciation? Or do you wait, risking losses when prices fall? You may continue to think of the company as a sound long-term investment, so you don’t want to sell; but you are worried about short-term corrections to market price. If you buy a LEAPS put in this situation, the downward price movement in the stock will be matched point for point by increasing value in the in-the-money LEAPS put. You also discount your basis by selling calls with rich time value premium, an alternative to profit taking that allows you to continue owning shares.

When you don’t own shares and market value has run up, buying a put is a speculative move. You anticipate a correction; when prices fall, you will experience a corresponding increase in value of the LEAPS put. Without taking a short position or selling uncovered calls—both high-risk strategies—you can profit if you are right when stock market prices fall, by owning the put. And because expiration is farther out, you have as much as three years to be proven right.

When you want to buy more shares and you believe the price is too high today, selling puts may work well for you. The premium you receive lowers your basis and risk, and as long as you consider the striking price a good price for shares, exercise would not be devastating. If share prices continue to rise, you keep the premium from selling the put. This strategy mitigates the dilemma for every stock investor: If you buy more shares today and prices then fall, you have a paper loss position. If you don’t buy more shares and the stock’s price rises, you miss the opportunity. Look at short puts as a possible solution to this dilemma.

Smart Investor Tip

Using LEAPS to time market swings or insure other positions is more practical than with short-term options. The longer time until expiration provides better value, enabling you to protect paper profits more economically.

The advantage of longer expiration overcomes the option buyer’s ongoing struggle with time, at least to a degree. In long positions, you will pay more for time value but you have more time. In a volatile market, your chances of profiting with LEAPS calls and puts are greater because expiration is not immediate.

In addition to trading in LEAPS on individual stocks, you can also buy or sell index LEAPS. These are somewhat more complex because the relationship between striking price and index value is not the same as for individual stocks.

American-style option

an option that can be exercised at any time before expiration. All equity options and some index options are American-style.

European-style option

an option that can be exercised only during a specified period of time immediately preceding expiration. Some index options are European-style.

capped-style option

an option that can be exercised only during a specified period of time; if the option’s value reaches the cap level prior to expiration, it is exercised automatically.

In addition, index LEAPS may be set up in one of three ways. An American-style option can be exercised at any time prior to expiration. All short-term options and LEAPS in stocks are exercised as American-style options. However, some index options are European-style options, which means that exercise is allowed only during a shorter period of time immediately before expiration. A third variation is the capped-style option. This gives the owner the right to exercise, but only during a specific time period before expiration. If the option reaches its cap value before expiration, it is exercised automatically.

Even in the most uncertain of markets, the right strategy can be found to match the circumstances and your own risk tolerance. Options become most interesting when you move beyond the decision to buy or to sell and begin exploring the many strategies in the range of spreads, straddles, and combinations. The next chapter shows how these work.