LEAP Option Spreads: Tame the Market With This Risk-Blasting Strategy
by Karim Rahemtulla, Options Expert
Tuesday, June 8, 2010: Issue #1276
Okay, let’s start with the facts…
- The stock market will remain volatile for the rest of the year.
- Europe is the key driving force behind this volatility and once the euro hits the bottom, it will signal that the crisis is nearing the end.
So with that said, you might be thinking, “Why not just wait until the end of the year to invest or until the euro has bottomed?”
If it were only that easy, I’d have retired to a tropical paradise many years ago!
What I can say is that if Europe gets its house in order, 2011 will present an explosive opportunity to make money. Until then, though, how do we translate the market’s 1%, 2%, sometimes even 3% intraday price swings into even greater profit swings for us? I’ll show you…
To Kill a Mocking Market
The market can be a humbling force for any investor, financial analyst, or writer. It often runs in the opposite direction than we predict, mocking our best judgment in the process.
And I’m not immune to making losing calls from time to time, regardless of what my marketing department would like me to say!
So whether the market rallies sooner than expected, or falls harder than expected, it’s important to have flexible strategies in place. Here’s a way to stay profitable or protected either way…
Low Dollar Risk… High Dollar Return With LEAP Options
The way we accomplish that is by using the old failsafe investment strategy – LEAP options.
Right off the bat, we reduce the amount of money that you’d ordinarily have at risk with a straight stock purchase by up to 90%. So we’re only risking 10% of our capital, with the maximum loss being 10% of what we’d pay to own the shares outright. That’s a far cry from a 25% stop loss… or worse.
Second, there’s a way of using LEAP options to reduce risk even further – and potentially enhance returns, too.
It’s called a spread play.
In a spread, your gains are limited to the difference between the two price points (i.e. the price of the options.) In return for this limited risk, the gains are also limited. Let me use an example to illustrate…
A Step-By-Step LEAP Spread Trade
Here’s the step-by-step process for a LEAP spread trade…
- Let’s say you have a stock at $20 that you think is headed to $30 by the end of 2012.
- You look at the $20 LEAP call options, which are for $4 per contract – 20% of the underlying share price. Stock market volatility has made them more expensive than usual. So how can you reduce that cost?
- The answer is to combine an options purchase and a sale, so that you offset the purchase price.
- You buy the $20 call for $4 ($4,000) and sell the $30 call for $2 ($2,000).
- Your net cost is now $2 per contract – 10% of the underlying share price. Remember, there are 100 shares in an option contract, so your actual net cost amount is $2,000.
- The profit potential is $8 – calculated by subtracting the net cost ($2) from the difference between the strike prices ($10). That’s a 4-to-1 return. On a 10-contract trade (equivalent to controlling 1,000 shares), that’s an $8,000 profit on $2,000 at risk.
Compare that to what the stock trade would cost. You’d pay $20,000 to make $10,000 – just $2,000 more in profit for $18,000 more in risk.
And what do you give up by slashing your risk? Well, you cap your gain. If the stock moves higher than $30, you get no more on your options trade, since you sold the right to buy the shares at $30 to someone else for that $2 premium you received.
And while the shareholder would have unlimited upside, holding shares in a volatile market can be risky business. Much riskier than it needs to be when you consider LEAP spreads.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- The Legged Spread Trade: Take 10 Cents and I’ll Show You How to Make It $2.50
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
- Potentially Grab Portfolio Gains Without Buying Shares or Risky Options
- The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
- How to Recover When Your Option Trades Turn Against You
8 Responses to “LEAP Option Spreads: Tame the Market With This Risk-Blasting Strategy”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
GENTS,
YOU USED AN EXAMPLE USING CALL LEAPS. WHY NOT TOMORROW USE AN EXAMPLE USING PUT LEAPS!
JEB
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Have you ever attempted to determine the proportion of your readers who are principally IRA investors as opposed to those investing their personal accounts? The former are not permitted to use call options whereas the latter, of course, can do so. In other words, the above info is useless to IRA investors.
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Wow, this statement couldn’t be more wrong. If your broker tells you that you can’t trade options in an IRA account, you need to fire that broker. I only trade options, and I trade them regularly in both a Traditional IRA account and a Roth IRA account. The only restriction I face in either account is that I cannot sell a naked short Call. [I can and do sell naked short Puts, though, as long as I am willing to get long the underlying stock if assigned.] Seriously, you should consider another broker….if for no other reason than your present broker is inadequately educated on rules for options in IRA accounts. Full disclosure: I use Thinkorswim.
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hey karim,
Should one only use leap spreads when the stocks trade with high IV?
if IV is low should one just use a straight call?
Your posts are very informative keep up the good work!
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Karim,
Is it good to use leap spread during times of low IV? Is a single leap call preferable?
Thanks for the great articles, keep up the good work!
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I have been looking at many sites and found yours extremely useful. There is clearly lots to learn on this subject. Can anyone recommend other good places to search for this information?
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I have been looking at many sites and found yours extremely useful. There is clearly lots to learn on this subject. Can anyone recommend other good places to search for this information?
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What type of option account is required to trade leaps put and call options in my IRA ?
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