Aug 13 2008
Leaping For Profits
It sounds almost too good to be true. Buy a LEAP call option and sell a near term call option and let time decay put money in your pocket. Over and over.
As you may recall (if you don’t, you probably need to brush up on your basic option theory), Theta-the value for time in option pricing-goes to zero as the option approaches expiration. Simply put, if an option has an extrinsic value (time value) of $3, that value will go to zero as time runs out on the option. An out-of-the-money option has only extrinsic value. An in-the-money option has intrinsic value and time value. Again, if a stock option that is in-the-money has a premium value of $8, which is made up of $5 intrinsic value (above strike price) and $3 time value, at expiration the stock option will have a value of $5 due to the total loss of extrinsic (time) value.
One way of using this property of time decay is to set up a strategy known as a Time Spread. A profit is made when the front decay increases the spread between the font and back months. For example, suppose a front month out of the money call is sold for $4.00 and the back month is purchased for $6.00. A profit is made when the front month expires with zero value and the back month still has value. In our example, the net cost of putting on this long time spread is $ 2.00. If the front month expires at $0 and the back month is at $5, the position has made a $3 net profit. So, logic says that the more stable the back month remains in price, the greater the spread. Thus, consider the LEAPS (Long-term Equity AnticiPation Securities).
Theta in a LEAP is very stable because there is a long time until expiration. On the other hand, the Theta for a near month is on the normal exponentially decreasing curve for an expiring option. Thus, the rather stable LEAP premium and the deteriorating near month can supposedly optimize the time spread.
When screening for a good front month candidate, a trader wants to locate a fairly stable stock but with a decent enough extrinsic value. As you may recall, extrinsic value is highest when the strike and the stock are at-the-money. So, to maximize premium value, a trader would want to locate a call option near or at the money to sell. However, the option should have a much implied volatility but not too much to move the stock too much into the money to possibly trigger an assignment.
For example:
IBM: Current price: $105
First trade
Sell (3) IBM March 08: Premium: $4.70 x 3 contracts x 100 shares= $1410
Buy (1) IBM Jan 2010: Premium: $10.50 x 1 x 100 = ($1050)
If Front month expires, trader keeps: $1450 premiums; net +$ 360
Second trade:
Sell (2) IBM April 08: Premium: $ 5.00 x 2 x 100 = $1000
No need to buy call to protect upside movement because you already own it.
If front month expires without being assigned, new balance is $+ 1360
Trader can repeat this reselling of OTM front month calls or puts to be as close to at-the-money as possible. The back end Leaps are perhaps traded once for each three or four front end sales.
For more information about the fantastic world of stock options, contact Options University (www.optionsuniversity.com) for a listing of online courses, webinars and seminars.
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