The LEAPS Option Trader
105 W. Monument Street
Baltimore, MD 21201
Thursday, September 15, 2005
#273
** To LEAP or Not to LEAP?
That is the question that I have been pondering for several months. When I began this service a couple of years back, it was based on several underlying assumptions:
1) It is wiser to risk fewer dollars if your time horizon is one, two, or three years – the usual length of a Leaps option trade.
2) All that is required for a substantial profit on your LEAPS option is a 10% to 15% move in the underlying share price, in the direction of your Leaps option.
3) Because the market is so unpredictable, and because we live in unpredictable times, it is prudent not to be fully invested in stocks when you can mitigate risk by using a derivative.
4) We would institute a stop-loss to further protect our principal.
Item 4 has been on my mind for some time. I strongly recommend using stop-losses for all types of investing. It is the smart thing to do. But, when using LEAPS, the stop-loss can actually be damaging in the short term.
LEAPS options are meant to mirror the movement of underlying share prices. However, recently there have been notable instances where the Leaps option is NOT acting in concert with the shares.
Two examples come to mind. The first is our short of D.R. Horton, the largest homebuilder in the US. When we shorted the shares, they were at $42. We bought the LEAPS puts with an out of the money strike. The shares fell more than $6 in a few weeks, but we only managed to walk away with a 10% to 20% gain.
The second instance was our purchase of AngloGold Ashanti LEAPS a few months ago. We were up 15% on this position at one time, only to see the gains evaporate when the price of gold headed south, and the shares fell by 10%. That fall in price caused us to stop out of our position. Today, the options are back over our entry price.
I looked back over the AngloGold pick. When it was made, we had two years on the option to make money from a move in the price of gold. It was a good pick. The LEAPS recommendation was accompanied by a 50% stop-loss. When the shares fell, the stop-loss was triggered. But, there was still more than one and a half years left on the option. The use of the stop-loss caused us to miss an opportunity.
Lately, I have been more liberal with the stop-losses, even removing them at times on certain positions. The issue that I see with investing with LEAPS is twofold. First, the spread between the bid and offer is wide, and that allows for games by the market makers to prompt selling – especially if they are aware that stops are waiting to be triggered. Believe it or not, they do know when a newsletter makes a recommendation.
Secondly, the LEAPS markets, while liquid, are not as liquid as the stock market. So, if there is no activity in a position, the options price tends to drift for a while until there is activity. We are witnessing that with our Microsoft option. The share price has barely budged – less than 5% – yet the option has fallen much more. Yet, just like Anglogold – this option has more than 2.3 years left on it. It is my opinion that Microsoft shares will move more than 10% higher from current levels over the next two years – I gave you the reasons why in the original release. This option (WMF AF) is a good buy at current levels of $2.
I will make changes to sell-stops – instituting new ones, removing others – on a more frequent basis in the future. A hard stop will rarely be used, unless we are in a very expensive option. Unless there is company specific news, we will not let a drifting option cause us to stop out of a position when we have a lot of time left and we require a small move in the underlying shares.
The bottom line is this: We are investing, in most cases, between 10% and 15% of what we would spend if we bought the same number of shares as we control with the options. That number is lower than we would normally apply as a stop-loss (20% or 25%) in a share position. We are taking LESS dollar risk, and yet we would be applying a much stricter dollar stop-loss. So, while we will always apply an initial stop-loss, be aware that it is not set in stone.
Regards,
Karim Rahemtulla
Bio:
Karim Rahemtulla is the former Investment Director of The Oxford Club. The editor of The Smart Options E-Report, The Income Trader – A Covered Call Strategy and The LEAPS Option Trader, Karim is also a regular contributor to The Oxford Club Communiqué. His highly successful trading systems use covered calls and LEAPS to boost returns on blue chip stocks, and during the bear markets of 2000 and 2001, his picks outperformed the major market averages. Educated in England, Canada and the U.S. and fluent in several languages, Karim travels the world to find the best investment opportunities for our members.
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