Covered Calls-Bullish

Covered calls are a way to earn additional income on your stock portfolio. For conservative investors, selling calls against a long stock position can be an excellent way to generate income.

Example

Let's imagine that you would like to purchase 100 shares of Disney (DIS) stock with the stock at $24.40. Pleased with the overall growth rate, you would like to hold the stock rather than sell it. Rather than just sitting back and collecting the Disney dividends, you can use options to generate additional income at minimal risk to you. You can do all of this in one transaction using our Covered Call screen.

With the stock at $24.40 you could sell one 27.5 call in the near month at $0.90. As each call is valid for 100 shares you are only able to sell one call.

DIS trading @ $24.40
Buy	100 DIS @ $24.40	$2,440
Sell	1 OCT 27.5 call @ $0.90	($90)
Cost of Trade		$2,350

Knowing the stock price hasn't fluctuated much, you might have confidence that it isn't going to move higher than $27.50 in the short term. After all, that would be a more than 10% move. At expiration, if the stock is still below $27.50, you keep the $90 you received by selling the calls and the 100 shares of stock. At that point, you might decide to write another call for a future month.

Should the stock rise unexpectedly above $27.50, you will have two choices. You can either buy the calls back and keep the stock. Or, you can let the stock be called away and sell your 100 shares (1 contract x 100 shares) at the strike price of $27.50. The good news, in this case, is that you participated in the rise from $24.40 to $27.50 on the 100 shares you sold at 27.5. In doing so, you locked in an additional $310 in profit. The bad news is that you may have capital gains tax issues to deal with-especially if you've owned the stock for a long time and your cost basis is low.

Using Near Month Options

When writing covered calls, most investors tend to sell near month options for two reasons. First, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Second, and equally important, is the role time decay plays in the value of the options. Like all out-of-the-money options, the call in the example above has no intrinsic value. As such, the only value is the time premium or time value which, in the final month before expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration.

Long Call - Bullish

Let's imagine you have a strong feeling a particular stock is about to move higher. You can either purchase the stock, or purchase 'the right to purchase the stock', otherwise known as a call option. Buying a call is similar to the concept of leasing. Like a lease, a call gives you the benefits of owning a stock, yet requires less capital than actually purchasing the stock. Just as a lease has a fixed term, a call has a limited term and an expiration date.

Example: Let's look at an example option. Microsoft (MSFT) is trading at $55.00, it would take $55,000 to buy 1000 shares of the stock. Instead of purchasing the stock you could purchase a MSFT "call option" with a strike price of 55 and an expiration 1 month in the future. For instance, in May you could Buy 10 MSFT JUN 55 Calls for $2.50. This transaction will enable you to participate in the upside movement of the stock while minimizing the downside risk of purchasing stock.

Since each contract controls 100 shares, you bought the right to purchase 1000 shares of Microsoft Stock for $55 per share. The price, $2.50, is quoted on a per share basis. As such, the cost of this contract is $2500 ($2.50 x 100 shares x 10 contracts).

MSFT trading @ $55.00
Buy	10 MSFT JUN 55 Call	$2,500
Cost of trade		$2,500

If the stock stays at or below $55 before the options expire, $2500 is the most you could lose. On the other hand, if the stock rises to $65 at expiration, the options will be trading around $10 (current price: $65 - strike price: $55). Thus, your $2500 investment will be worth $10,000 ($10 x 100 shares x 10 contracts).

If the stock price increases, the option gives you two choices: sell or exercise the call. Many investors choose to sell because it avoids the substantial cash outlay involved in exercising your call option. In the example above, to exercise you would pay $55,000 ($55 x 1000 shares) to buy the stock when you exercise the options. At a market price of $65, your shares would actually be worth $65,000. Not including commissions, you would have made a $7,500 profit on your $2500 investment ($10,000 - $2500).

Compare this to selling the options: you realize the same profit without spending the money to buy the shares. With the stock at $65, the Jun 55 calls would be worth $10 per contract. Thus, each option contract would have a value of $1,000 ($10 x 100 shares * 10 contracts). Not a bad return for a $2500 investment!

The scenario described above is a great example of the leverage that options provide. Just look at the returns on a percentage basis.

	Purchase $	Sale $	Profit	% Gain
Stock Price	$55	$65	$10	18.2%
1000 Shares	$55,000	$65,000	$10,000	18.2%
10 Jun 55 Calls	$2,500	$10,000	$7,500	300%

As the chart above demonstrates, if you bought 1000 shares of stock at $55, you would be putting $55,000 at risk. If you sold the stock when it rises to $65, you make $10,000 on your $55,000 investment, a 18.2% return. In contrast, investing $2500 in call options only puts $2500 at risk. In this case, the return is 300%.

Now, let's see what happens when the stock drops.

	Purchase $	Sale $	Profit	% Gain
Stock Price	$55	$45	($10)	(18.2%)
1000 Shares	$55,000	$45,000	($10,000)	(18.2%)
10 Jun 55 Calls	$2,500	$0	($2,500)	(100%)

While this scenario looks scary on a percentage basis, when you look at the raw numbers, it's clearly relative. If the stock drops, your calls may expire worthless, but your loss is limited to your initial investment, in this case $2,500. In contrast, the stockholder sustains a far larger dollar loss of $10,000. When you compare the limited downside and the unlimited upside potential of call options, it easy to see why they are such an attractive investment for bullish investors.

Volatility & Equity Options

Successful equity option trading requires opinions on three variables concerning the underlying stock: expected price direction, timing of the expected move, and the stock's future volatility. Although most investors appreciate the importance of a formed opinion on price movement and timing when selecting an option, it is consideration of the stock's future volatility that is usually ignored or not understood.

What is volatility? Mathematically, volatility is the annualized standard deviation of daily returns. A simple definition, however, is the fluctuation of stock prices without regard to direction. Big average daily stock price changes (up or down, in percentage terms) means high volatility, and small average daily price changes means low volatility.

To be able to make a forecast of a stock's future volatility we need to have an understanding of the role that volatility plays when pricing an option. The easiest way to accomplish this is comparing the pricing of an option contract to the pricing of an insurance contract.

Options can serve as insurance policies? In a manner of speaking, yes. Just as the insurance policy owner desires to transfer the risk of owning real property to someone else at a fee, an investor can purchase an option contract to protect their cash or stock positions against market fluctuations by paying a premium to someone else to assume the risk. Because of the leverage options convey, many investors assume they are meant only for speculation. By definition, however, options are instruments of risk transfer. They evolved because of a need for protection, or insurance, against wild price fluctuations in agricultural markets. To understand further how options work as insurance products, consider the following two examples.

Through the purchase of equity puts on a share-for-share basis with owned stock, an investor has the right to sell the underlying stock at a fixed price for a specific length of time. This right to sell may protect the owner of the underlying stock against a decline in price until that option's expiration. By purchasing equity calls, an investor has the right to buy the underlying stock at a fixed price for a specific length of time. This right to buy may insure a cash position against a price increase in the underlying stock until the option's expiration. Although the put protects against a "real loss" and the call against an "opportunity loss," both types of options may protect an investor from unfavorable events, acting as insurance polices in every respect.

To continue the comparison, both the insurance company and the options marketplace must consider risk when establishing a contract's premium. Insurance companies hire actuaries to evaluate the potential risk of writing policies. When would an actuary's job be the most difficult? Consider an actuary sitting in a client's home with a hurricane expected to arrive in hours trying to evaluate the risk factor for the homeowner's policy. In this case, the actuary could justify inflating the policy's premium because of the potential for damage that the hurricane's winds pose. If the hurricane suddenly diverted its course away from the house, the risk would diminish considerably and the actuary might price the policy at a more modest level.

As with an insurance policy, potential risk is considered in the pricing of an option contract; however, the risk comes from the possible price fluctuations of the underlying stock, i.e. its volatility. A market maker pricing that option in the marketplace makes a forecast of the stock's future volatility.

When might pricing an equity option be difficult? Imagine a market maker pricing an option on the underlying stock of a company expected to announce earnings the next week. A discrepancy between the analysts' expectations and the announced earnings could cause the stock price to fluctuate dramatically. The market maker might inflate the option's premium in order to offset this potential volatility risk. If after the earnings are announced there is reduced uncertainty about future stock price changes, the market maker could justify lowering the option's premium.

Taken to another level, volatility can be considered three ways. First, there is historical volatility, which is simply the measure of actual stock price fluctuations in the past. Second, there is forecasted volatility, or an estimate of the future volatility in an underlying stock. Third, there is implied volatility, or the volatility assumption that results in the actual price of an option in the marketplace. It reflects a consensus of the marketplace as a whole on the forecasted volatility of an underlying stock.

Using this new vocabulary let's apply it to an example. Companies which are in the headlines are frequently the favorites of speculators buying options. When doing so many will have opinions on just price direction and timeframe, and pay little attention to implied volatility. Consider this scenario.

With the historical volatility of XYZ stock at 27%, a XYZ 30-day at-the-money call option was initially trading at an implied volatility of 25%. However, because of a recent 2 for 1 stock split announcement by XYZ, the implied volatility of the option contract had risen to 40%. As a result of this increase, the option contract, which previously traded for $1 �, or $150, was now trading for $2 �, or $250. News of the split prompted a speculator to purchase this option with the expectation of reselling the contract at a 100% return on investment in a week's time. However, the speculator did not consider implied volatility and paid $250 for an option contract which had historically been trading for $150. In this case, after the initial reaction to the news subsided, the implied volatility returned to historical volatility levels, resulting in a decrease in the option's premium. Although fluctuation in an option's premium is often the result of movement in the stock price, the fluctuation of this option's premium was the result of movement in its implied volatility. Because of implied volatility fluctuation, the speculator must now wait for a larger movement in the stock's price to reach the investing goal of 100% return.

Understanding how volatility affects option premiums enables traders to complete a three-part forecast: expected price direction of the underlying, timing of the expected move, and the stock's future volatility. Although there is no guarantee that a forecast will be correct, including a prediction on the stock's future volatility in the decision-making process gives traders an improved chance of achieving their intended results.

Volatility

If you are unfamiliar with the concept of volatility, you might want to review the previous section on pricing options.

Implied Volatility

Before we examine the ways professional traders use volatility in conjunction with theoretical pricing models, it's important to note that these calculations are all done by computer programs. What typically happens is that traders plug their volatility assumptions into the computer and have instant access to theoretical option values at a wide range of stock prices.

Although not all traders rely on models, those that do use a volatility assumption, usually based on a historical value, as a barometer for where they believe options should be trading. At the same time, traders monitor the actual market prices to determine what is known as implied volatility. By plugging real-time option prices into a theoretical model (instead of a volatility assumption), the same equation can be used to calculate the volatility of each option. For example, while the 90 day volatility of a stock may be 25%, the current option prices may imply higher or lower volatilities even for the same expiration month.

Stock XYZ Corp:

Price $54 per share
Historical Volatility: 25%

Option	Implied Volatility
Sep 40 call	18%
Sep 45 call	23%
Sep 50 call	38%
Sep 55 call	42%
Sep 60 call	27%
Sep 65 call	29%

Some professional traders have sophisticated programs that continually monitor the implied volatilities of every exchange traded option looking for options that are significantly underpriced or overpriced relative to their historical volatility. These options are then either bought or sold and hedged against other options or stock. In the example above, if a program determined that the volatility of the September 55 call (42%) was statistically significant relative to other options, the trader might decide to sell the 55 calls and buy the 40 or 45 calls as a hedge.

Trader Psychology

Discipline

Anyone seriously interested in trading would do well to buy a copy of Jack Schwager's books Market Wizards and The New Market Wizards. Through interviews and conversations with America's top traders, Jack extracts the wisdom that separates successful traders from those who, through their trading, simply add to the wealth of successful traders.

One of the key factors mentioned by almost every good trader is discipline. Discipline, as you might imagine, takes a variety of forms. For beginning traders, one of the toughest challenges is to keep trades small. Believe it or not, more than a few top traders don't allow any one position to account for more than 1% of their total portfolio. Linda Bradford Raschke, one of the traders featured in The New Market Wizards, attributes much of her success to managing risk in this way. As a result, her average trade, at the time the interview, had a profit of only $450. At the same time, her average loss was only $200. Keeping her position small didn't impede her profit though. By remaining disciplined, she earned over $500,000 trading that year.

Limiting Your Losses

Another aspect of trading that involves discipline is limiting your losses. Here, there isn't a magic formula that works for everyone. Instead, you have to determine your own threshold for pain. Whatever you decide, stick to it. One of the biggest mistakes people make is to take a position with the intention that it be a short-term trade. Then, when the position goes against them, they make a seamless and unprofitable transition from trader to long-term investor. More than a few people have gone broke waiting for the trend to reverse so they could get out at break-even. If you are going to trade, you have to be willing to accept losses--and keep them limited!

Another mistake novice traders make is getting out of profitable positions too quickly. if the position is going well, it isn't healthy to worry about giving it all back. If that's a concern, you might want to liquidate part of the position or use options to lock in your profit. Then, let the rest of it ride. Mark Ritchie, one of the founders of CRT, an extraordinarily profitable Chicago-based trading company, once kept a trade on for 4 years because it kept working for him. Not every trader has that kind of patience. And not every trader makes as much money as Mark Ritchie.

It isn't uncommon for people to view trading as a fast-paced, exciting endeavor. Fast-paced? Absolutely. Exciting? Now that's a matter of opinion.

The Importance of Remaining Even-Tempered

More than a few traders interviewed in The New Market Wizards emphasize the importance of remaining unemotional and even-tempered. To these people, trading is a game of strategy that has nothing to do with emotion. Emotion, for these traders, would only cloud their judgment.

In the book, Charles Faulkner, a Neuro-Linguistic Programming trainer talks about one trader who was extremely emotional. Although Faulker was able to show him how to be less emotional and more detached, it became quickly apparent didn't enjoy being emotionally unattached. He found it boring. Unfortunately, emotion involvement in trading comes at a high price. Before too long, that trader went broke. The morale of the story is simple: If you insist on being emotionally attached to your trading, be prepared to be physically detached from your money.

Acceptance and Responsibility

One of the most interesting interviews in the book was with Robert Krausz, a member of the British Hypnotist Examiners Council who specializes in working with traders. According to Krausz, one of the biggest mistakes traders can make is to agonize over mistakes. To beat yourself up for something you wish you hadn't done is truly counterproductive in the long run. Accept what happens, learn from it and move on.

For the same reason, it's absolutely crucial to take responsibility for your trades and your mistakes. If you listen to someone else's advice, remember that you, and you alone, are responsible if you act on the advice.

Another Way to View Losses

Perhaps the most striking example of emotional distance in trading mentioned in Schwager's book was attributed to Peter Steidlmayer who reacts to positions that go against thinking to himself, "Hmmm, look at that." If only we could all be that calm!

Of all the emotions we could possibly experience, fear and greed are possibly the two most damaging.

Fear

Of all the emotions that can negatively impact your trading, fear may be the worst. According to many of the traders interviewed in The New Market Wizards, trading with scared money is an absolute recipe for disaster. If you live with the constant fear that the position will go against you, you are committing a cardinal sin of trading. Before long, fear will paralyze your every move. Trading opportunities will be lost and losses will mount. To help deal with your fear, keep in mind what fear is:

Confidence

The flip side of fear is confidence. This is a quality that all great traders have in abundance. Great traders don't worry about their positions or dwell on short-term losses because they know they will win over the long term. They don't just think they'll win. And they don't just believe they'll win. They KNOW they'll win. As Linda Bradford Raschke put it, "It never bothered me to lose, because I always knew that I would make it right back." That's what it takes.

To Talk or Not to Talk

For many traders, sharing opinions and taking a particular stance only magnifies the stress. As a result, they begin to fear being wrong as much as they fear losing money. Although it may be one of the hardest lessons to learn, the ability to change your opinion without changing your opinion of yourself is an especially valuable skill to acquire. If that's too hard to do, the alternative may prove much easier: Don't talk about your trades.

Greed

Greed is a particularly ugly word in trading because it is the root cause of more than a few problems. It's greed that often leads traders to take on positions that are too large or too risky. It's greed that causes people to watch once profitable positions get wiped out because they never locked in profits and instead watched the market take it all back.

Part of the remedy for greed is to have, and stick to, a trading plan. If you faithfully set and adjust stop points, you can automate your trading to take the emotion out of the game. For example, let's say you are long the 50 calls in a stock that rises more rapidly than you ever expected. With the stock at $77, the dilemma is fairly obvious. If you sell the calls, you lock in the profit but you eliminate any additional upside potential. Rather than sell the calls, you might buy an equal number of 75 puts. The $25 profit per call that you just locked in will more than offset the cost of the puts. At the same time, you've left yourself open to additional upside profit.

Gradual Entry and Exit

Another strategy successful traders use is to gradually get in and out of positions. In other words, rather than putting on a large trade all at once, buy a few contracts and see how the position behaves. When it's time to get out, you can use the same strategy. Psychologically, the problem people have implementing this strategy is that it takes away the "right" and "wrong" of the decision making process. It's impossible to be completely right or completely wrong using this strategy because, by definition, some of the trades will be put on at a better price than others.

Awareness & Instincts

For floor traders especially, instincts often play a crucial role in trading. To truly appreciate this, just close your eyes and imagine making trades in a fast market with dozens if not hundreds of people screaming around you. In this environment, it becomes absolutely essential to maintain a high level of awareness about everything going on around you. Then, to have the confidence to pull the trigger when necessary, you have to trust your instincts. It's absolutely amazing to see how some floor traders, even in a busy market, know exactly who is making what trades. For these traders, expanded awareness is often a necessary prerequisite to fully developing and trusting their instincts.

The same is true for off-the-floor traders as well. Watching how markets behave and developing a feel for the price fluctuations is truly time well spent. Unfortunately, in this era of technology, people have become so removed from their natural instincts that many are no longer in touch with their intuition. This is unfortunate because intuition functions as a wonderful inner guidance system for those who know how to use it.

One trader interviewed by Jack Schwager in The New Market Wizards relies so heavily on his intuition that he didn't want his name in the book for fear his clients would be uncomfortable with his strategy and move their money elsewhere. Speaking anonymously, he described in detail how he establishes a rhythm and "gets in sync" with the markets. In this way, he has learned to distinguish between what he "wants to happen" and what he "knows will happen." In his opinion, the intuition knows what will happen. With this knowing, the ideal trade is effortless. If it doesn't feel right, he doesn't do it.

When he doesn't feel in sync with the markets, this trader will virtual trade until he feels back in rhythm. But even here, he keeps his ego and emotion out of it. His definition of out of sync is completely quantifiable. Being wrong three times in a row is out of sync. Three mistakes and it's back to the virtual trading. Now there's a strategy almost everyone can benefit from.

Time & Risk

Quick changes can speed you forward or take the wind out of your sails.

Volatility is the speed with which an investment gains or loses value and the frequency of those changes. The more volatile an investment is, the more you can potentially make or lose in the short term. For example, equities tend to change price more quickly than most fixed-income investments (bonds and bank deposits). But it's not always that simple. The price of stock in large, well-established companies tends to change more slowly than stock in smaller, or newer, companies. And the more predictable a company's business, the slower the price fluctuation is apt to be. There are other factors to consider, too. Low�rated, high-yield bonds, often known as junk bonds, and some bond funds fluctuate in price at least as often as stocks, and offer some of the same opportunities for gain � and loss. Junk bonds may provide higher income than other bonds in the short term but are more likely to default on their obligations to pay principal and interest, just as some speculative stocks may lose all their value.

Time and Risk

Volatility poses the biggest investment risk in the short term. Sometimes if you wait, and hold onto your equity investments until a market downturn ends and recovery begins, its effect may be reduced. Similarly, if you hold onto your bond investments until maturity, changing market values have no impact on their par value or their interest payments.

Volatility may pose several serious problems, though. If you have been planning to sell an investment to pay for the down payment on a home, college tuition, or any other goal, you may not have enough to cover your costs if its price has fallen dramatically. Or, you may be so concerned over the falling value of your investments that you sell. Not only does that lock in your loss, but you'll no longer own the investment. If its price rebounds, you can't share in its potential recovery. But, of course, your investment may not recover even if the market rebounds.

Historically, major drops in the stock market � including market crashes and bear markets, when the value of stocks drops 20% or more � have been ultimately followed by a period of recovery. If you look at the big picture, you'll discover that what seems to be a huge drop in price often evens out when it is part of a long-term pattern.

Another way to deal with volatility is to capitalize on it. If an equity increases dramatically in value, you can sell it and make another investment. Then, if the price of the equity you sold drops, you can buy it again and wait to see if the cycle will repeat itself. The one investment strategy that's pretty much doomed to failure is trying to time the market, or predict what the stock and bond markets are going to do next so you can be in the right place at the right time. The reason? It can't be done. Or at least nobody has been able to do it successfully over a period of time.

Watching the Movement

If you recognize a certain trend in stock prices, you may be able to turn it to your advantage. For example, some investments, known as cyclicals, move in identifiable patterns, up in certain economic climates and down in others.

If you invest when a cyclical stock is down and sell when it's up, you benefit from the movement. One problem, of course, is knowing when to get in and out.

Other investments are more volatile and less predictable. For example, technology stocks (and the mutual funds that invest in them) jumped dramatically in value during 1995. But in the years before that many of them performed rather poorly.

Reading the Wind

The range between an investment's high and low price over a period of time � often a year � is one measure of its volatility. The smaller the percentage of change the less volatile the investment.

For example, a stock that increases in value from $15 a share to $20 a share over the course of a year has a 33.3% volatility rate, while a stock that increases from $45 to $50 over the same period has a volatility rate of 11.1%. The assumption is that a stock that increases by a large percentage could easily fall by the same percentage, providing a potential loss.

One strategy some investors use to avoid volatility is to sell stock when its price increases or drops a predetermined percent, often in the range of 10% to 20%. One way to handle this approach is to put in a limit order, an instruction to your broker or advisor to sell any investment automatically when it drops to the level that you set.

No Pain, No Gain

Illogical as it may seem, predictability is sometimes a bigger stumbling block to achieving your long�term investment goals than volatility. For example, the rate of return on a bank issued certificate of deposit (CD) is predictable. The problem is that while what you earn on the CD may be higher than the return on a stock, bond, or mutual fund during a market downturn, it doesn't have the potential to increase in value. When the CD matures, you can roll the principal and interest into a new CD at whatever the current rate is. But you can't sell the CD for more than you paid for it, and you can't earn more than the current rate that's being offered. What's more, while what you can earn on a CD increases when interest rates are high, your real rate of return, after taxes, is rarely greater than the rate of inflation.

Volatility's Reward

Don't get the mistaken impression that volatility is to be avoided at all costs. It can work in your favor at least as dramatically as it can work against you. In fact, a strong stock market often produces rapidly increasing prices in a relatively short time. That, in turn, can increase the value of your investment portfolio.

Leveling Out Your Risk

You can neutralize the impact of volatility with a buying strategy known as dollar cost averaging. Using this approach, you invest the same amount regularly in a specific investment, such as a mutual fund, paying whatever the going price is. When the price goes up, your dollars buy fewer shares. When it goes down, they buy more. The effect, over time, can be to lower the cost of the average share of stock or mutual fund you buy, so that you end up with more shares for less money. But remember that while dollar cost averaging has advantages if you invest consistently over time, it doesn't guarantee a profit or protect you from losses in a falling market.

Selling Short

Some stock investors take added risks in the hope of greater returns.

Not all stock trades are straightforward buys or sells. There are several strategies you can use to increase your gains, though they also increase your risk of incurring losses. Among these strategies are selling short and buying warrants. Both are based on a calculated wager that a particular stock will change in value, either dropping quickly in price � for a short sale � or increasing, for a warrant.

How Short Selling Works

While most investors buy stocks they think will increase in value, others invest when they think a stock's price is going to drop, perhaps substantially. What they do is described as selling short.

To sell short, you borrow shares you don't own from your broker, order them sold and pocket the money. Then you wait for the price of the stock to drop. If it does, you buy the shares at the lower price, turn them over to your broker (plus interest and commission) and keep the difference.

For example, you might sell short 100 shares of stock priced at $10 a share. When the price drops, you buy 100 shares at $7.50 a share, return them to your broker, and keep the $2.50-a-share difference � minus commission. Buying the shares back is called covering the short position. In this case, because you sold them for more than you paid to replace them, you made a profit. And you didn't have to lay out any money to do it.

You borrow 100 shares at $10 per share from your broker
You sell the shares at the $10 price getting $1,000
	You profit if stock price drops	You lose if stock price rises
Stock price	$7.50	$12.50
Shares you owe your broker	100 Shares	100 Shares
Your cost to pay back the shares	$750	$1,250
Profit or loss	$250 profit	$250 loss

What are the Risks?

The risks in selling short occur when the price of the stock goes up � not down � or when the drop in price takes a long time. The timing is important because you're paying your broker interest on the stocks you borrowed. The longer the process goes on, the more you pay, and the more the interest expense erodes your potential profit.

An increase in the stock's value is an even greater risk. If it goes up instead of down, you will be forced � sooner or later � to pay more to cover your short position than you made from selling the stock. That means you lose money.

Squeeze Play

Sometimes short sellers are caught in a squeeze. That happens when a stock that has been heavily shorted begins to rise. The scramble among short sellers to cover their positions results in heavy buying, which drives the price even higher.

Short Interest Highlights

Trading activity in stocks that have been sold short on the New York Stock Exchange and the American Stock Exchange and not yet repurchased is described as short interest. The volume of short interest gives you a sense of how many investors expect prices to fall, and the stocks they expect to be affected.

Selling short often increases when the market is booming. Short sellers believe that a correction, or drop in market prices, has to come, especially if the overall economy does not seem to be growing as quickly as stock values are rising. But short selling is also considered a bullish sign, or a predictor of increased trading, since short positions have to be covered.

The average daily volume, which is the average number of shares sold short each trading day during the month, and the percentage change during the month are reported in the financial press for each company that has had at least 550,000 shares sold short or a change of short interest of at least 250,000 shares in the month.

In addition, graphs track the recent history of short interest and summary tables provide the names of the companies with the largest short positions and the greatest change. You may also find a graph showing the short interest ratio. That's the number of days it would take to cover the short interest in selected stocks if trading continued at a consistent pace.

Buying Warrants

Like a short sale, a warrant is a way to wager on the future price of a stock - though a warrant is less risky. Warrants guarantee, for a small fee, the opportunity to buy stock at a fixed price during a specific period of time. Investors buy them if they think a stock's price is going up.

For example, you might pay $1 a share for the right to buy a stock at $10 within five years. If the price goes up to $14 and you exercise, or use, your warrant, you save $3 on every share you buy. You can then sell the shares at the higher price to make a profit [ $14 - ($10 + $1) = $3 ], or $300 on 100 shares.

Companies sell warrants if they plan to raise money by issuing new stock or selling stocks they hold in reserve. After a warrant is issued, it can be listed in the stock columns and traded like other investments. A wt after a stock table entry means the quotation is for a warrant, not for the stock itself.

If the price of the stock is below the set price when the warrant expires, the warrant is worthless. But since warrants are less expensive than purchasing the stock outright and have a relatively long lifespan, they are traded actively.

Pricing Options

The Key Factors in Determining an Options Price

To anyone just becoming familiar with options, understanding how options are priced can be one of the greatest challenges. Until the early 1970s, only cumbersome mathematical models existed to help traders determine the theoretical value of an option. Since these models involved complex equations and market prices changed constantly, they didn't prove especially practical.

In 1973, two University of Chicago mathematics professors, Fischer Black and Myron Scholes devised a model that even today remains a standard for many option traders. The Black-Scholes Model, as it is known, was such an important advancement that the professors earned a Nobel Prize for their work.

Theoretical Value

The Black-Scholes Model, or any model for that matter, is not always representative of what happens in real life. Models are limited by the numerical inputs used to calculate the theoretical value of an option. They will never be able to take into consideration qualitative factors like market sentiment. For this reason, the theoretical prices and actual market prices may bear little resemblance.

Having said that, let's look at the quantitative factors that impact an option's theoretical value:

• Strike price
• Time remaining until expiration
• Price of the underlying stock
• Volatility of the underlying stock
• Interest rates
• Dividends

Strike Price and Intrinsic Value

The strike price plays a significant role in the market price of an option because it determines whether an option has any intrinsic value. For example, if the underlying stock is trading at $84 an 80 call will have $4 of intrinsic value because it gives the call owner the right to buy the stock for $80. At the same time, the 80 put will have no intrinsic value because it doesn't make sense to sell a stock for $80 when it can be sold for $84 on the open market. In this situation, whatever value the put has will be purely extrinsic (time) value.

As you can see on the table below, the closer an option is to the current stock price, the more extrinsic value it has. Conversely, the further in- or out-of-the-money the option is, the lower its extrinsic value.

AT&T Corporation (NYSE: T)
Stock Price: 19.00

Option	Price	Intrinsic Value	Extrinsic (Time) Value
Calls
Dec 12.50	6.60	6.50	0.10
Dec 15.00	4.20	4.00	0.20
Dec 17.50	1.90	1.50	0.40
Dec 20.00	0.55	-	0.55
Dec 22.50	0.15	-	0.15
Dec 25.00	0.10	-	0.10
Jan 12.50	6.70	6.50	0.20
Jan 15.00	4.40	4.00	0.40
Jan 17.50	2.05	1.50	0.55
Jan 20.00	0.75	-	0.75
Jan 22.50	0.25	-	0.25
Jan 25.00	0.10	-	0.10
Puts
Dec 12.50	0.05	-	0.05
Dec 15.00	0.10	-	0.10
Dec 17.50	0.35	-	0.35
Dec 20.00	1.50	1.00	0.50
Dec 22.50	3.70	3.50	0.20
Dec 25.00	6.10	6.00	0.10
Jan 12.50	0.10	-	0.10
Jan 15.00	0.15	-	0.15
Jan 17.50	0.65	-	0.65
Jan 20.00	1.90	1.00	0.90
Jan 22.50	3.90	3.50	0.40
Jan 25.00	6.30	6.00	0.30

Deep-in-the-money options tend to move on in tandem with the underlying stock. Thus, when the stock moves $1, the option value also changes by $1. With deep out-of-the-money options, the situation is a bit different. Since it would take a significant move in the underlying stock to increase the likelihood that a deep out-of-the-money option finishes in the money, people aren't usually willing to pay much for them. As a result, they tend to have low extrinsic value. At the same time, these options have no intrinsic value.

Time Remaining Until Expiration

Unlike the strike price of an option which remains fixed, the time remaining until expiration changes over the life of the option. As an option approaches expiration, the time value tends to decrease more rapidly. The rate at which an option loses value is often referred to as theta.

Time value is also known as extrinsic value because it represents the premium people are willing to pay above and beyond an option's intrinsic value. For example, in the table below, a December 20 call for AT&T is considered out-of-the-money because the strike price (20) is higher than the current market price ($19.00). As such, the price of the December 20 call ($0.55) consists exclusively of time value.

AT&T Corporation (NYSE: T)
Stock Price: 19.00

Option	Price	Intrinsic Value	Extrinsic (Time) Value
Calls
Dec 12.50	6.60	6.50	0.10
Dec 15.00	4.20	4.00	0.20
Dec 17.50	1.90	1.50	0.40
Dec 20.00	0.55	-	0.55
Dec 22.50	0.15	-	0.15
Dec 25.00	0.10	-	0.10
Jan 12.50	6.70	6.50	0.20
Jan 15.00	4.40	4.00	0.40
Jan 17.50	2.05	1.50	0.55
Jan 20.00	0.75	-	0.75
Jan 22.50	0.25	-	0.25
Jan 25.00	0.10	-	0.10
Puts
Dec 12.50	0.05	-	0.05
Dec 15.00	0.10	-	0.10
Dec 17.50	0.35	-	0.35
Dec 20.00	1.50	1.00	0.50
Dec 22.50	3.70	3.50	0.20
Dec 25.00	6.10	6.00	0.10
Jan 12.50	0.10	-	0.10
Jan 15.00	0.15	-	0.15
Jan 17.50	0.65	-	0.65
Jan 20.00	1.90	1.00	0.90
Jan 22.50	3.90	3.50	0.40
Jan 25.00	6.30	6.00	0.30

Not surprisingly, the January 20 call is worth more than the December 20 call because it has an additional month of time value before expiration. In other words, because the stock has an extra month to move beyond the 20 strike price, people are willing to pay more for the January 20 call than for the December 20 call.

At-the-Money vs. Out-of-the-Money

Another important point to notice on the table above is the relationship between the strike price and the time value of the options. With the stock at 19.00, the 20 strike is considered the most at-the-money. For puts and calls alike, this strike has the highest time value. As we move further away from the current stock price, in either direction, the time value decreases. For example, the deep in-the-money December 12.50 calls have only 0.10 cents in time value while the at-the-money December 20 calls have 0.55 cents.

This makes sense when you consider that the time value is nothing more than the price that people are willing to pay for the chance that an option will finish in-the-money. An option that is far out-of-the-money with almost no chance of finishing in-the-money won't command a particularly high price. Similarly, an option that is already deep-in-the-money can be readily exercised and converted to stock. For these reasons, the contracts that tend to trade most frequently are the options that are at or near-the-money. In a sense, these strike prices command a higher extrinsic value because there is more uncertainty as to whether or not the options will finish in-the-money.

Price of the Underlying Stock

The price of the underlying stock impacts option prices in a number of ways. First, and most basic, the relationship between the stock price and a given strike price determines whether an option has intrinsic value, extrinsic value, or both.

When the strike price is below the current market price, calls will have intrinsic value and puts will not. In the table above, the January 12.50 calls have 6.50 points of intrinsic value while the January 12.50 puts have no intrinsic value at all. Like the January 12.50 calls, the December 12.50 calls have 6.50 of intrinsic value (19.00 - 12.50), but less extrinsic value (0.10 vs.0.20) because there is less time remaining on the contract. In some cases, deep-in-the-money options have intrinsic value but no extrinsic value. In this situation, the options are said to be trading at parity. For example, if the December 12.50 calls were priced at 6.50 rather than 6.60, they would be at parity.

Hedging and Theoretical Value

When using a theoretical model like Black-Scholes, the exact price of the underlying is important because it impacts the price traders are willing to pay for any given option. For example, it isn't enough to know that the stock is trading at $45.50 because a trader may need to buy or sell stock to offset option contracts. For example, if the market for the stock is really 45.25 - 45.50, a trader will only receive 45.25 selling the stock. Thus, the option values should be based on a stock price of 45.25 rather than 45.50. This seemingly small spread can make the difference between a profitable and an unprofitable trade.

Volatility of the Underlying Stock

The volatility of the underlying stock may be the most important factor in pricing options because unlike the other numerical inputs which have an exact value, volatility can only be known with certainty from a historical standpoint. At any given moment, the strike price, the current market price, and a few relatively minor factors we haven't examined yet (i.e., prevailing interest rates, stock dividends) are all exact numbers that people know and agree upon. With volatility, that isn't the case.

What is volatility?

In simplest terms, volatility is the tendency of a stock to fluctuate and the likelihood that it will be within a particular price range at a specific moment in time. The higher the volatility, the more prone a stock is to large price swings. Conversely, low volatility stocks tend to show a history of stable prices.

Low Volatility

Some stocks, like utilities, tend to be relatively stable over time because their earnings are relatively predictable. People who invest in these stocks often do so for the slow, steady growth and consistent dividends. At the same time, they want secure investments they don't have to monitor everyday. With these low volatility stocks, the daily price changes are generally fractional. While the long-term trend may be up, the short term trend may even appear to be sideways. A good example of this is Ameren (NYSE: AEE), a large Midwestern utility. Looking at Ameren from the point-of-view of an options trader, we see a 52-week range between $46.50 and $37.43. Given this level of stability, even an untrained chart reader could predict the price range over the subsequent months with a high degree of accuracy. Considering the low likelihood that the stock would deviate from this pattern of low volatility, the market for options on this stock was quite small in terms of volume and price. This is confirmed by the options chain:

Ameren (NYSE: AEE)
Stock price: 44.67

Calls	Price	Vol.		Puts	Price	Vol.
Dec 40	4.90	0		Dec 40	0.25	0
Dec 45	0.80	0		Dec 45	1.50	0
Dec 50	0.20	0		Dec 50	6.10	0
Mar 40	5.00	0		Mar 40	0.65	0
Mar 45	1.15	0		Mar 45	2.60	0
Jun 40	5.00	0		Jun 40	1.15	0
Jun 45	1.55	10		Jun 45	3.30	0
Jun 50	0.30	0		Jun 50	7.30	0

High Volatility

Other stocks, like Internet and biotechs tend to have larger daily price swings. The bigger the price swings, the more volatile the stock. When assessing stock volatility, traders look at a particular period of time (e.g., 90 days). However, it may be necessary to look at volatility over a shorter period, particularly when recent developments change the long-term outlook for a company.

From an options trading standpoint, it makes sense that people would be willing to pay more for options on a stock that has a higher likelihood of making a profitable move during the life of the option. As we can see, that's exactly what happens.

Let's take EBAY, Inc. (Nasdaq: EBAY) as an example. Here's a stock that had some fairly significant price swings in a relatively short period of time. The 52-week range on this stock was from $30.88 to $61.60. Given this level of volatility, it stands to reason that options on this stock would be significantly more expensive than they would for a stable utility like Ameren. Again, this is confirmed by the option chain:

EBAY, Inc. (Nasdaq: EBAY)
Stock price: 56.35

Calls	Price	Vol.		Puts	Price	Vol.
Dec 40	16.60	149		Dec 40	0.15	120
Dec 45	11.70	173		Dec 45	0.25	233
Dec 50	7.20	413		Dec 50	0.80	177
Dec 55	3.60	517		Dec 55	2.20	34
Dec 60	1.45	103		Dec 60	5.00	0
Dec 65	0.50	477		Dec 65	9.10	0
Dec 70	0.15	9		Dec 70	13.80	13
Jan 40	16.80	9		Jan 40	0.35	0
Jan 45	12.20	47		Jan 45	0.65	223
Jan 50	8.00	10		Jan 50	1.50	100
Jan 55	4.60	47		Jan 55	3.10	67
Jan 60	2.30	149		Jan 60	5.90	16
Jan 65	1.05	14		Jan 65	9.70	10
Jan 70	0.50	30		Jan 70	14.00	7

As you might imagine, there are several advantages to trading options on volatile stocks. As we've already discussed, there is a greater likelihood that the options will finish in-the-money. Although the options tend to be more expensive, they also tend to be more liquid. This is an important consideration because whether you are getting in or out of the market, you want to get the best price. The more frequently the contracts trade, the more likely that market competition will maintain a tight bid-ask spread.

If for some reason, the actual volatility of the options decreases, the options will lose value faster than their less volatile counterparts. However, that's a known risk most traders are willing to take. In fact, many traders make their fortunes selling options when volatility is high and covering their positions when the market becomes less volatile.

Position Management

efore establishing any position it's important to establish a few guidelines for yourself:

• Are you trading with money you can afford to lose?
• Is the position you intend to put on sufficiently small that it won't have a major impact?
• What is your specific objective for this position? What is your exit strategy?
• What is your downside risk?

Are you trading with money you can afford to lose?

The importance of this cannot be overstressed. If you have already earmarked the money for another use, it is not advisable to invest it in a risky position--even for a short term trade. Every day the market extracts money from people who can't afford to lose it. Don't be one of them.

Is the position you intend to put on sufficiently small that it won't have a major impact on your portfolio?

This is a guideline novice traders routinely violate. Experienced traders caution people against putting on positions that will have devastating results if the market moves the wrong way. Some traders go so far as to say that positions should be so small that putting them on seems almost meaningless. Typically, the percentage of your portfolio associated with this would be 1/2% to 1%. Keep in mind though that this applies to traders more than long-term investors. This is not to say that investors wouldn't benefit from the same advice. They probably would. It's just that a disciplined approach is particularly beneficial to option traders who could easily lose their entire investment.

What is your specific objective for this position? What is your exit strategy?

These issues are inter-related so we will examine them together.

First, whenever you put on a position, it's important to set a price target along with a strategy for what happens when you get there. For example, if you are convinced a particular Internet stock is hugely overvalued (imagine that!) and due for a correction, you might decide to buy a long put either at-the-money or slightly out-of-the-money. If the market behaves as you predict and the price drops, you have to decide how far to let your profits run and at what point to take profits.

If the stock drops 50% and your put is now deep in-the-money, this might be a good time to take profits. On the other hand, if you think the stock is still overvalued, you could buy a slightly out of the money call and let the put ride. For example, if the stock dropped from $100 to $49 and you own the 95 put, you could lock in your profit by buying a 50 call. This way, if the stock goes back up, what you lose in the put will be made up by the call. If the stock continues to drop as you hope, the put will increase in value and the call will expire worthless. Whatever you decide, it's good to have your strategy thought out in advance. This helps to take the emotion out of it.

What is your downside risk?

With option spreads and other advanced strategies, your maximum loss may be more than your initial investment. Before entering into any trade, it's important to know your maximum profit, maximum loss, and break-even. Trading surprises are seldom pleasant.

Modifying and Managing a Position

Depending on market conditions, option investors may need to modify their positions either to lock in profits or protect themselves from adverse moves.

Protecting Your Profits

Taking the easiest example, let's imagine you bought a long call and watched with interest as the stock rallied. How can you protect what is now a paper profit? Considering the additional stock commissions involved in exercising the option, we'll disregard this as a strategy and focus on other alternatives.

The dilemma whenever a position makes money is when to take profits and when to let profits ride. By selling the call, you lock in profits, but you may miss additional upside. On the other hand, if you sit tight, the stock could pull back below the strike price. In this case, you would lose your additional investment as well as your paper profit. Fortunately, there are other alternatives.

Now, let's imagine you bought an AT&T August 35 call for 1.75 when the stock was trading at 33.38. Shortly afterwards, the stock rallied to 42 where your call was worth 8.5. Rather than sell the call, lock in the profit and walk away (which is a perfectly acceptable strategy), you might sell the 35 call and buy the September 45 call for 1.5. The profit you make on the Aug 35 call will more than cover your investment in the September 45 call. As long as the stock climbs, you can continue to lock in profits by rolling your options to higher strike prices and subsequent months.

The other possibility would be to transform the position into a bull spread by holding the August 35 call and selling the August 45 call. With AT&T at $42, the August 45 call will probably be trading around 1.35. By selling the 45 call, you effectively own a 10 point bull spread for .4 of a point (1.75 - 1.35). If the stock continues to rise, 10 points (less your .4 point investment) will be your maximum profit. Should the stock suddenly drop back below $35, the most you can lose would be .4 point or $40.

The important point to note is that the riskiest course of action is to do nothing because your initial investment remains at risk along with any paper profits you have generated.

Limiting Your Losses

Let's imagine you bought an AT&T August 35 call for 1.75 when the stock was trading at 33.38. Shortly afterwards, the stock dropped to $30 where your call was only worth $1. If you sell the call, you may limit your losses, but you'll also eliminate the opportunity to profit from a rebound in the stock. On the other hand, if you sit tight, the stock might never regain strength in which case you'll lose your initial investment. Here again, there are other alternatives.

Rather than sell the call, lock in the loss and walk away (which is a perfectly acceptable strategy), you might consider selling two August 35 calls at 1 and buying one Aug 30 call for 2.65. This way, you will create a bull spread using the 30 strike because you will be long one 30 call and short one 35 call. Thus, for an additional .65 investment, you now have increased the likelihood that the position will be profitable. Before, the stock would have had to go over 36.75 for you to make a profit. Now, the break even is 32.35.

The other possibility would be to transform the position into a calendar spread by holding the August 35 call and selling the July 35 call at .75. This course of action would make sense if you expected the price to remain depressed through July but expected a rally shortly afterwards. Ideally, the short July 35 call would expire worthless and the stock would rally as expected. If the stock rallies before July expiration, the price differential between the July and August 35 calls may be limited as will your profit potential. In contrast, if the stock fails to gain strength, your maximum loss using this strategy is significantly less than it was before you put on the calendar.

Here again, the riskiest course of action is to do nothing because the full value of your initial investment remains at risk.

LEAPS Strategies

The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices. This strategy is often compared to purchasing insurance on one's home or car, and may give investors the confidence to remain in the market. The amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost, should be considered.

For example, ZYX is trading at 45 and a ZYX LEAPS put with a three-year expiration and a strike price of 42.5 is selling for 3.5 or $350 per contract. These puts provide protection against any price decline below the break-even point, which for this strategy is 39 (strike price less the premium). The investor's risk or maximum loss is limited to the total amount paid for the put options or $350 per contract. The following are possible outcomes of this strategy at expiration.

Stock above the break-even point

If ZYX is trading at 48 at expiration, the unexercised put would generally expire worthless, representing a loss of the option premium or $350 per contract.

Stock below the strike price

The put would be profitable if the stock closed below 39 at expiration. If ZYX is trading at 37.5 at expiration, the 42.5 put, upon exercise, would have a value of 5 or $500, representing a profit of 1.5 points or $150 per contract. This profit will partially offset the decline in the value of the stock.

Stock between the strike price and the break-even point

If ZYX is trading at 41.5 at expiration, the 42.5 put would be valued at approximately 1. This means that, upon exercise, a portion of the option premium would be retained and the loss would then be 2.5 points or $250 per contract. If the contract is not exercised or sold, the investor will lose all of the initial investment, or $350 per contract.

Sell LEAPS Covered Calls

The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.

The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.

Investors should be aware of the risks involved in a covered call strategy. Call writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price. The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.

The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS call. ZYX is currently trading at 39.5, and a ZYX LEAPS call option with a two-year expiration and a strike price of 45 is trading at 3.25.

An investor owns 500 shares of ZYX at $39.5 per share and sells five of ZYX LEAPS calls with a strike price of 45 at 3.25 each or a total of $1,625. The investor's objective is to obtain profits without selling the stock. The break-even point for this covered call strategy is 36.25 (the stock price of 39.5 less the premium received of 3.25). This represents downside protection of 3.25 points. A loss will be incurred if ZYX declines to below 36.25. Possible outcomes of this strategy at expiration are as follows.

Stock above the strike price

If ZYX advances to 50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of 45 less the price of the stock when the option was sold plus the option premium received of 3.25 X 100).

Stock below the break-even point

If ZYX is trading at 34 at expiration, the unexercised LEAPS calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.

Stock between the strike price and the break-even point

If ZYX advances to 40 at expiration, the LEAPS calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of 3.25 per share.

LEAPS Contract Specifications

Unit of Trade: Generally 100 shares of stock per unadjusted contract.

Premium (Price) Quotations: Stated in points and fractions; one point equals $100. The minimum price change for series trading below 3 is .05 ($5) and for all other series is .10 ($10) per contract.

Exercise: Equity LEAPS are American-style options. The option may be exercised prior to the expiration date.

Exercise Settlement: A holder that tenders an exercise notice on any business day will receive delivery of the underlying stock on the fifth business day following the date of exercise. The exercise settlement price equals the strike price multiplied by 100 (multiplier) for unadjusted series.

Expiration Cycle: Equity LEAPS expire in January of each year.

Expiration Date: Expiration occurs on the Saturday following the third Friday of the expiration month.

Position Limits: LEAPS positions are aggregated with other options with the same underlying asset. Limits vary according to the number of outstanding shares and trading volume. Hedge exemptions may be available. Contact exchanges for details.

Trading System: Market Maker/Designated Primary Market Maker/Lead Market Maker/Specialist/Registered Option Trader (depending on the exchange).

Leaps

LEAPS ( Long Term Equity Anticipation Securities) merupakan Opsi jangka panjang , jangka waktu 1 tahun atau lebih dan selalu expired di bulan Januari.

Jika ingin memiliki suatu saham, nasabah mempunyai pilihan dengan memiliki LEAPS saja. Jadi tidak perlu membeli sahamnya tetapi cukup LEAPS nya saja ( LEAPS Call ). Atau jika ngin memproteksi suatu saham dari kerugian yang besar , nasabah bisa memiliki LEAPS Put untuk memproteksi dalam jangka panjang ( 1 tahun atau lebih).

While using LEAPS does not ensure success, having a longer amount of time for your position to work is an attractive feature for many investors. In addition, there are several other factors that make LEAPS useful in many situations.

• How LEAPS Work
• Availability of LEAPS
• LEAPS Pricing
• LEAPS Symbols
• Time Erosion vs. Delta
• LEAPS Strategies
• LEAPS Contract Specifications

Stock Alternative

LEAPS offer investors an alternative to stock ownership. LEAPS calls enable investors to benefit from stock price rises while placing less capital at risk than is required to purchase stock. Should a stock price rise to a level above the exercise price of the LEAPS, the buyer may exercise the option and purchase shares at a price below the current market price. The same investor may sell the LEAPS calls in the open market for a profit.

Diversification

Investors also use LEAPS calls to diversify their portfolios. Historically, the stock market has provided investors significant and positive returns over the long term. Few investors purchase shares in each company they follow. A buyer of a LEAPS call has the right to purchase shares of stock at a specified date and price up to three years in the future. Thus, an investor who makes decisions for the long term can benefit from buying LEAPS calls.

Hedge

LEAPS puts provide investors with a means to hedge current stock holdings. Investors should consider purchasing LEAPS puts if they are concerned with potential price drops on stock that they own. A purchase of a LEAPS put gives the buyer the right to sell the underlying stock at the strike price up to the option's expiration.

What's the Downside?

If you are a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price you paid for the position. If you are an uncovered seller of LEAPS calls, there is unlimited risk, or a seller of LEAPS puts, significant risk. Risk varies depending upon the strategy followed, and it is important for an investor to understand fully the risk of each strategy.

Stock Versus LEAPS

There are many differences between an investment in common stock and an investment in options. Unlike common stock, an option has a limited life. Common stock can be held indefinitely, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument. As a result, even if an option investor correctly picks the direction the underlying stock will move, unless the investor also correctly selects the time frame that movement will take place, the investor will not profit as desired.

Options investors run the risk of losing their entire investment in a relatively short period of time and with relatively small movements of the underlying stock. Unlike a purchase of common stock for cash, the purchase of an option involves "leverage," whereby the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.

How LEAPS Work

LEAPS are simply long-term options that expire at dates up to 2 years and 8 months in the future, as opposed to shorter-dated options that expire within one year.

LEAPS grant the buyer the right to buy, in the case of a call, or sell, in the case of a put, shares of a stock at a predetermined price on or before a given date. Equity LEAPS are American-style options, and therefore may be exercised and settled in stock prior to the expiration date. The expiration date for Equity LEAPS is the Saturday following the third Friday of the expiration month.

LEAPS are quoted and traded just like any other exchange listed option. In fact, many of the features of LEAPS are the same for shorter-term options:

• Number of shares covered by the contract (100)
• Exercise and assignment procedures
• Trading procedures
• Margin and commission costs

Availability of LEAPS

Several factors impact the availability of LEAPS. When options are listed for trading on a particular stock, most times LEAPS are not immediately available. After a period of time, and if interest warrants it, the exchanges listing the shorter-term options may decide to list LEAPS options, after consulting with the market-makers or specialists assigned to trade the stock options. The reason for this is that LEAPS options are difficult to price because of their long life. The exchanges ensure that sufficient interest is present in the market, and that market-makers or specialists are prepared to price and trade longer-dated options once they are listed. The result is that LEAPS are not available on every stock which has options traded on it. LEAPS are initially listed with three strike prices, at the current price and 20 to 25% above and below the price of the underlying stock. Strikes may be added as the underlying stock moves. LEAPS only have one expiration month: January in two different years.

As LEAPS draw within one year of their expiration and it becomes necessary to list new LEAPS series, the existing LEAPS options continue to be listed and traded until their expiration. However, because of the shorter length of time until expiration, they then trade as ordinary shorter-term options and they lose their distinctive LEAPS symbols. New LEAPS options with expiration dates in the future are then added.

LEAPS Pricing

Options pricing models contain five factors that are used to determine a theoretical value for an option: stock price, strike price, time to expiration, interest rates (less dividends) and volatility of the underlying stock.

With shorter-term options, it is fairly straightforward to use an interest rate which approximates the "risk-free" interest rate; most people use the U.S. Treasury-bill rate (90-day). However, to price a LEAPS option, it is necessary to predict the volatility (expectation of price fluctuation) of the underlying stock and interest rates over 2 1/2 years; this is difficult even for most professionals.

In short, pricing longer-term options is more difficult than pricing shorter-term options. Of the five factors mentioned above, interest rates play a more significant role in the pricing of longer-dated options, due to the length of time involved. For these reasons, professionals are not ready to instantly quote prices of options with maturity dates far into the future, since the predictability of the inputs is so much more unreliable than for shorter-term options.

Despite these difficulties, investors will find that exchange policies generally require market-makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS whenever the decision is made to use them.

LEAPS Symbols

In order to differentiate LEAPS from shorter-dated options, LEAPS have a different set of symbols for retrieval on quotation systems. While other options have fixed symbols, LEAPS symbols change to reflect the expiration year.

Motorola (MOT)

Option	Symbol	LEAPS Option	Symbol
OCT ('02) 15 call	MOT JC	JAN ('04) 15 LEAPS call	LMA AC
JAN ('03) 15 call	MOT AC	JAN ('05) 15 LEAPS call	ZMA AC
APR ('03) 15 call	MOT DC

This feature makes it easy to distinguish a longer-term option from a shorter-term option in data listings.

Time Erosion vs. Delta

One of the most challenging aspects of shorter-term options is the erosion of the "time premium" portion of the option's price. Time premium refers to the amount of the option's price that exceeds its intrinsic value. As an option nears its expiration date and the time period shortens, the marketplace is less and less willing to pay any premium over intrinsic value until, at expiration, an option is trading purely for intrinsic value.

As a seller of shorter-term options, time premium erosion works in your favor. Conversely, the option buyer has to overcome the erosion of time premium to make a profit from a long option position. The graph below is a representation of theoretical time erosion for longer-dated options:

Any stock or options symbol displayed are for illustrative purposes only and are not intended to portray a recommendation to buy or sell a particular security.

As you can see from the graph, time erosion of options premium is not linear (i.e. it does not occur in a straight line). The mathematical reasons for this are complex, but the result is that the erosion of time premium in the earlier months of an option's life is much less dramatic than the erosion that occurs in the last few months. Because of the long time frame of LEAPS options, this effect is even more pronounced. The time erosion that occurs in the first several months of a LEAPS option is minimal.

However, when LEAPS options become shorter-term options (time to expiration is less than one year), they behave like all other shorter-term options, as the graph shows. Time erosion becomes more pronounced and has a greater impact, especially in the last 90 days of the option's life.

What does this mean to options investors? Buyers of LEAPS options have less time premium erosion to fight than buyers of shorter-dated options. The tradeoff, however, is that LEAPS options offer less "leverage." The deltas of LEAPS options will not increase dramatically as with shorter-dated options since there is so much time remaining until expiration. Any increase in option value due to an increase in the price of the underlying stock will be tempered by this lower "gamma" effect.

The slow time erosion will frustrate LEAPS sellers. However, the premiums available to writers, because of the increased time in LEAPS options, can provide a good rate of return in covered writing and other strategies.

Buy LEAPS Calls

An investor anticipates that the price of ZYX stock will rise during the next two years. This investor would like to profit from the increase without having to purchase shares of ZYX.

ZYX is currently trading at 50.5 and a ZYX LEAPS call option, with a two-year expiration and a strike price of 50, is trading for a premium of 8.5 or $850 per contract. The investor buys five contracts for a total cost of $4,250, which represents the total risk of the call position. The calls give the investor the right to buy 500 shares of ZYX between now and expiration at $50 per share regardless of how high the price of the stock rises. To be profitable, though, at expiration, the stock must be trading for more than 58.5, the total of the option premium (8.5) and the strike price of 50. The buyer's maximum loss from this strategy is equal to the total cost of the options or $4,250. The break-even point for this strategy is 58.5.

The following are possible outcomes of this strategy at expiration.

Stock above the break-even point

If ZYX advances to 65 at expiration, the LEAPS will have a value of approximately 15 (the stock price of 65 less the strike price of 50). The investor may choose to exercise the calls and take delivery of the stock at a price of 50, or may sell the LEAPS calls for a profit.

Stock below the strike price

If ZYX, at expiration, is trading for less than the strike price, or below 50 in this example, the unexercised calls will expire worthless. In this case, the investor will incur the maximum loss of $4,250.

Stock between the strike price and the break-even point

If ZYX, at expiration, has risen to 56, the calls will be valued at approximately 6 (the stock price of 56 less the strike price of 50) and will represent a partial loss given the break-even point of 58.5. The calls purchased by the investor for 8.5 will, upon exercise, then be worth approximately 6, creating a loss of 2.5 points or $250 per contract. If the investor does not exercise or sell these options, the investor will lose all of the initial investment, or $850 per contract.

Prior to expiration, the LEAPS may trade at a price that is somewhat higher than the difference between the 50 strike price and the actual stock price This difference is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration. Time value is one of the components of an option premium and generally decreases as expiration approaches.