Last week, CNBC announced that the Chicago Board of Options Exchange (www.cboe.com) will begin offering binary options on the S&P 500 and the volatility index (VIX) on July 1st. Now binaries have been used in the currency markets for some time, but they’re relatively new to the stock market. The first binaries were introduced on the AMEX on May 5th, less than two months ago. So what are they and why would an investor want to play them?

Binaries are Fixed Return Options
A binary or fixed return option (FRO) is an all-or-nothing bet, just like betting on a horse. If Old Nelly wins, the amount you receive is the size of your bet times the odds. If the nag loses, you’re out the cost of your bet. That’s exactly how an FRO (as binaries are called on the AMEX) works. The FRO term for a call is Finish High and Finish Low for a put. Both types of options can be bought or sold, just like a regular option, but unlike regular options, binaries aren’t subject to implied volatility and to a lesser extent, time decay which make them easier for the novice investor to understand. Because they’re tied to an underlying security or index, FROs can be traded through a regular broker, although most require at least a Level 2 designation on your account. (FROs can be traded in retirement accounts as well.)

All binaries are of the European type meaning that they can only be exercised on the last day of trading before expiration, typically the third Friday of the expiration month. At expiration, the options holder (buyer) will receive $100 per contract if the price at expiration is at or above the strike price for calls (Finish High options) and at or below the strike price for puts (Finish Low options). An options seller will get to keep the premium collected on the option if it expires out of the money, but will be forced to pay $100/contract if it expires at or in the money. The maximum loss that an options buyer can incur is the cost of the initial transaction (plus commissions), and for the options seller, his maximum loss is ($100 – initial premium taken in by the sale) x the number of contracts. Contrast this capped loss with the theoretically unlimited loss of selling a naked standard options call and you can see why using binaries for this type of trade are a lot more desirable.

Binary options use a cumulative distribution function to determine their value instead of the Black-Scholes formula used to calculate the price of standard options. A good rule of thumb in determining the price of a binary is to use the value of delta on the corresponding standard option. For example, an at-the-money call will have a delta of 0.50 which should be the price of the binary. Deep in-the-money calls will have binaries priced near one, and those far out-of-the-money will have binary prices close to zero.

Currently, the AMEX offers FROs on 20 of the more widely-held and heavily traded stocks and ETFs, including AAPL, C, CSCO, DIA, EEM, GE, GOOG, GS, HD, IBM, INTC, IWM, JPM, MSFT, OIH, QQQQ, SPY, WB, XLE, and XLF. (See www.amex.com for the list and their corresponding FRO options chains.) Most of the above stocks come with strikes up to three months out; some come with strikes up to a year away. Checking through some of these option chains, I found that most of them are thinly traded (not uncommon for a new product) and come with astronomic bid/ask spreads. For example, the spreads on the SPY are 15 cents, and a July at-the-money strike has an open interest of only 20.

One cause for concern is the settlement pricing of these options. To prevent large investors or institutions from artificially manipulating the price of the underlying stock or ETF on expiration day, the AMEX does what is called VWAP pricing on their FRO products. Now we looked at the VWAP, or volume weighted average price, in a previous blog and saw that it’s nothing more than the total value of all trades made during a certain period (here the period is one day) and dividing it by the total number of shares traded. Although VWAP pricing can remove some price manipulation, I don’t know if it can remove all of it, especially on the more thinly traded stocks and ETFs.

The Upside to Binaries
The upside is that binaries are a lot easier for the casual investor to understand–you either win or you lose, it’s that simple. They’re also cheaper than standard options since their prices are capped at $100/contract making them affordable investment tools for the small investor. Another advantage is that you can buy them without worrying that you’re paying a premium arising from inflated implied volatilities. In fact, in times of high volatility the binary may be the preferred choice for the options holder (buyer). Also, hedgers can use them in place of a covered call to avoid giving up any upside price movement. If you think that the underlying might expire within certain price levels, you can construct binary spreads to take advantage this.

The Downside to Binaries
The newness of these products gives rise to liquidity issues as well as to large bid/ask spreads, but increased product interest should mitigate these factors. One major downside to binaries is that your profit is capped. If you happen to be right, you might be kicking yourself for not buying a regular option instead.

Conclusion
Since binaries are such a new product, I haven’t had much time to digest their significance and possible uses. I can’t say right now if they make attractive additions to everyone’s portfolios but I do think that they might afford some cheap catastrophic insurance to those holding large positions in one of the above mentioned stocks or index ETFs. The coming months will surely tell if binaries are viable or not. Stay tuned!

While surfing the market, I stumbled upon a life insurer called Presidential Life (PLFE) and remarked at what a great channeling stock it’s been for about the last year. (See chart below.) Harking back to my Chocolate Channeling Bar recipe that I posted in my 2/8/08 blog, I decided to see if there were other stocks in the insurance group that might be exhibiting channeling behavior and by cracky you know what? I found some more.

You’ll remember that the definition of a channeling stock is one that repeatedly trades between a support and resistance level. A channel is typically horizontal, but it can have an upwards or downwards bias to it, too.* The idea is to buy the stock when it bounces off the lower level, sell it when it hits the upper level, and then short it on its way back down.** One caveat is that sometimes the price never quite reaches one of the levels. This is where you need to be alert and have stop losses in place. Other than that, this strategy is actually quite a fun one and can be very profitable, too.

One good thing about a lot of channeling stocks is that they tend to be in cyclical groups. Sure, the companies are less exciting but the good news is that they tend to pay dividends. This gives you extra bang for your buck when you’re on the long side (provided you purchase the stock before the ex-dividend date). Without further ado, here’s a list of my candidates from the insurance group along with dividend yield and percent upside return. (The upside return was calculated by taking the range value (top of range – bottom of range) and dividing it by the bottom range value. Note that the corresponding downside return value will be less.)

If you look at the charts of the above stocks, you’ll see that most of them are nearing the bottom of their channels. If you’re interested in playing any of these, wait until they bottom out and start to turn around. And don’t forget to set your stop losses!

Amid today’s somber events– a jump in oil prices, further downgrades in the financial sector, GM hitting a 53 year low, and the S&P breaking the 1300 support level*–there was one bright spot that seems to have gone by relatively unnoticed: That is the announcement that First Citizens Bank will merge with Community Bankshares. Why am I making a big deal out of it? For one reason: It can make you and me money.

The terms of the deal, approved by both boards, is for shareholders of SCB to receive $21 in cash for each share of common stock. At this moment, SCB is trading at $19/share, and the $2 premium represents a 10.5% return. Now the deal faces the usual regulatory hurdles and is subject shareholder approval but nowhere in any of the press releases was anyone quoted as being skeptical that the deal won’t go through. Company principals expect the deal to close sometime in the fourth quarter which is also good news since SCB shareholders will receive at least two dividend checks. Currently, the dividend is $0.12/share so that adding in two dividend periods will increase the six-month (or so) return to 11.8% (about 24% annually) and three dividend periods will increase the six-month return to 12.4%. Now I know this isn’t exactly a “wow!” type of return, but it is about as risk-free as you can get on a pure stock play.**

That’s my tip on this cloudy day in the market. If you look hard enough, there’s always a silver lining somewhere.

*CNBC claims that 1300 is a key support level for the S&P 500 but if you look at the chart you’ll see that 1275 is the real key level, and unfortunately it appears that it’ll be tested very soon.

**Check out my April 29th and 30th blogs for more details including returns and draw-downs on post takeover announcement plays.

Disclosure: I added SCB earlier today to my personal portfolio at a price of $18.85.

Besides rumors of Microsoft restoking interest in Yahoo, the major news on CNBC today concerned inflation, and no wonder. Prices across the board have been going up. Besides asking what the Fed is going to do about it tomorrow in their interest rate decision, a more important question and one that certainly hits closer to home is how can one prepare for increasing prices?

I know, I know. There’s been a rash of articles written lately from how to save money at the pump (car pool, take public transportation, take advantage of gas card offers) to how to save money on food (buy in bulk, frequent lower-end retailers, clip coupons, eat less meat). These are all ways to spend less now, but I haven’t run across anyone except for me who is saying “Buy more now!”

I don’t mean that you should go out and make frivolous purchases or buy things you’ll never use. What I mean is that if you know you’re going to make a major purchase in the future, you might save quite a few bucks by buying it in the present. Speaking in a CNBC interview this morning, a spokesperson for Lowe’s said that the company is trying to keep costs down to attract consumers but it doesn’t know how long it can continue to do that. Copper cable was cited as a commodity that has recently risen sky-high and the company said that it won’t be able to contain the price for too much longer. And Lowe’s isn’t the only boat sailing on the rocky sea of rising prices. Pretty much every business is being affected, most notably the energy-driven transportation stocks.

Buy the goods
So what can one do about it? You can buy now, while prices are still being held artificially low. Let’s say you’re thinking of adding a room to your house or remodeling your kitchen later this year. Chances are that prices will be much higher in several months compared to where they are currently. If you know what you’ll need, you can purchase it now at a savings. (Of course you’ll need to pay for it and find a place to store it.)

What about travel? If you know you’ll be home for the winter holidays or are thinking of taking a winter cruise, you may want to buy your travel tickets now. Not only will you lock in today’s price, but you might be able to spare yourself extra fees that the airlines and cruise companies are starting to impose.

The home electronics category, however, isn’t subject to the same rules. As newer technologies replace older ones, prices on outdated merchandise begin to drop. This means that buying a state-of-the-art wide screen TV today may not be such a wise purchase, especially if you’re willing to wait for it.

Short the sellers
I’ve shown you some areas where you might be able to save some dime on your personal purchases but are there retail-oriented stocks out there that might benefit from increasing prices? The answer, unfortunately, is no. Rising prices in a recessionary environment spell trouble for everyone, and common sense says that people will curb their spending across the board. First to go are the middle to high-end stores. Will people still want to shell out $4 for a cup of joe at Starbuck’s when they can either make it at home or buy it for a buck at McDonald’s? (I’ve had Mickey D’s java and it ain’t that bad.) Will they still pay $15/pound for organic beef at Whole Foods or buy USDA Choice at a regular grocery store for half the price?

The writing on the wall is clear. Is there any money to be made in this sector? We shall see. Looking through some of the charts in the sector, I’ve come up with a list of the best and worst performing stocks. I wouldn’t buy any of the better stocks right now, though, since they’re all in a slump and look like they may continue their downward trends. But the news isn’t all bad as you’ll find some great shorting candidates on the worst stock lists.

Major Discount Retailers
Best: Wal-Mart (WMT), BJ’s Wholesale (BJ)
Worst: Sear’s (SHLD)–hands down the worst stock in this group–a great short play

Deep Discount Retailers
Best: Big Lots (BIG), Fred’s (FRED)
Worst: 99cent Stores (NDN), Tuesday Morning (TUES)

Grocery Stores
Best: Kroger (KR)
Worst: Pantry (PTRY), Whole Foods (WFMI)–another great short play

Luxury Retailers
There are no winners in this space. Tiffany’s (TIF) broke major support two days ago. Coach (COH), Sotheby’s (BID), Saks (SKS), and Nordstrom’s (JWN) are all hovering around major support levels.

Mid-Level Retailers
Bad: There’s no bright spot here, either. Bon-Ton (BONT), Cost Plus (CPWM), Gottchalk’s (GOT), and Kohl’s (KSS) are all trading at multi-year lows.
Worst: Macy’s (M) and Dillard’s (DDS) win worst of breed. Macy’s has lost close to 60% of it’s value in little over a year, but Dillard’s wins the losing game by shedding two-thirds of it’s value in less time than that. Both charts are coyote ugly; buying long-term puts on either would be an excellent move.

Conclusion
I really hate to be the constant bearer of bad news, but it looks like we’re in for a bumpy ride in the retail consumer staples sector. If you’re holding long positions here, I strongly urge you to lighten up or at least put on a hedge. For all you bears out there, this sector–especially the worst stocks–should brighten your day as well as your bottom line.

It’s always tough getting back into the swing of things on Mondays, especially after spending a leisurely weekend sampling wine in one of our local wine-making regions. (It was fun but it was also a toasty 114 degrees.) Being in a summer slacker mood, I thought I’d take the easy route and check out what I’ve done before. Lo and behold I stumbled across the earnings experiment I began in February 28th’s blog where it was hiding at the bottom of the blog portfolio heap. I’m glad I resurrected it because the results are quite interesting.

The Premise
The premise was to see what happens if one buys stocks whose charts gapped up on good earnings news, and short stocks whose charts have gapped down because of bad earnings reports. So, what I did was to construct two portfolios consisting of five stocks each. The Good News portfolio consisted of equal dollar amounts ($5k/stock) of the following five stocks that reported great earnings on 2/28: Hurco (HURC), VisionChina (VISN), Chart Industries (GTLS), Ctrip (CTRP) and Fluor (FLR). The Bad New portfolio consisted of equal dollar amounts ($5k/stock) of the following five stocks that fell on negative earnings news: RH Donnelly (RHD), Abitibibowater (ABH), Dollar Thrifty Automotive (DTG), Sprint/Nextel (S), and Cowen Group (COWN). End of day prices were used as the cost basis along with $9.95/trade commissions. (No margin calculations are included, however.) The following two tables show the profit/loss profile per trade as well as the overall gain/loss.

We Southern Californians living near the coast experience an early summer weather pattern of heavy morning fog that sometimes burns off by mid-afternoon. We call this pattern “June Gloom.” Unfortunately, this pattern not only applies to the weather but also to the current market climate. Not only do I see gloom written all over the charts of the major indices but I see potential doom, too, at least in the short term. My wish is not to bum you out especially in front of the first weekend of summer, but to make you aware of internal conditions so you won’t be caught in a downpour without an umbrella.

Indications of impending inclement weather
The market had been staging a nice recovery since mid-March but a pall began to form over it on May 19th when two things happened. First, the VIX staged a turnaround. Since then it has been making a series of higher highs and higher lows, with each low bouncing off its 20 day moving average (dma). The VIX is a measure of uncertainty and runs contrary to the overall market so that when the VIX moves higher, the market moves lower. Whenever the VIX moves and stays over a value of 20 is my signal to lighten up on long positions and initiate short ones. (The VIX is currently trading over 23.)

May 19th was the turning point for the major stock indices, too. The large topping tails shown by all of them, including the Dow Transports, signalled that buying interest had dried up. When there’s no one left to buy, the only direction left for the price to go is downward. But how far might it go?

A gloomy prognostication
Charts of the major indices all show a similar pattern. As an example, let’s look at the weekly chart of the Dow Industrials to see if it can tell us where we might be headed.

The chart shows two head and shoulders patterns:* One is an inside pattern that ranges from April to December of 2007, and the other is a larger pattern that ranges from October 2006 to today. Once the right shoulder is broken, one can expect the price to decline by roughly the distance from the neckline to the top of the head. For the Dow, the first price target given by the inner pattern is calculated like this:

Price at the top of the head = 14,000
Neckline price at the right shoulder = 13,000
Total distance = 14,000 – 13,000 = 1,000

Therefore, the first price target is 12,000 (13,000 – 1,000) which is exactly where the second neckline formed. The second price target, calculated from the outer pattern, shows a support level at 10,000. Doing similar calculations for the S&P and the Nasdaq yields the following support levels:

S&P 500
First support level: 1300
Second support level: 1080

Nasdaq Composite
First support level: 2200
Second support level: 2000

The Dow is breaking through its right shoulder as we speak and the S&P is not far behind. The Nazzie, however, is doing better. It’s touching on 2400, a support level, and if it breaks through that the next stop is 2200. The techs have been doing fairly well lately so maybe they’ll help keep this index afloat.

A Ray of Hope
There’s no silver lining to be found in this thunder cloud, but if there is one ray of hope it will probably come from a turnaround in the banking and brokerage sector. Today isn’t the day, however, as both the financial spyder (XLF) and the regional bank holders (RKH) are hitting new five year lows. Sure, the high price of oil and other commodities are contributing factors, but I truly feel that the clouds won’t be clearing until investor uncertainly dissipates concerning the fate of the credit crisis. The Dow Transport Index is regarded as a leading indicator of market direction, but I think this time we need to add the XLF and RKH to our radar screens. I believe these charts need to stabilize first before we see the market turn around. But until the sun comes out, the best place for conservative investors is in cash or cash equivalents.

Don’t let the market rain on your parade!

*See Cooking Tools #1 (March 5th blog) for a discussion on how to interpret head and shoulders patterns.

CNBC’s Fast Money show had a bracket stock challenge several months ago. It was structured just like the NCAA basketball playoffs where teams, or in this case stocks, are matched up against each other. The number one seed this year as in last year’s competition was Berkshire-Hathaway (BRK). In the initial round, the number one seeds are always pitted against the bottom seeded teams; in this case, Berkshire was paired against Ambac Financial (ABK). Of course, everyone on the show picked Berkshire saying the selection was a no-brainer, but I picked Ambac. I do admit to having a stubborn streak but I’m not a die-hard contrarian. I prefer to take the rational approach and actually look at the stock charts and check out the fundamentals. Although Ambac has been hit hard by the credit crisis and its chart just plain sucks (that’s the technical financial term), my feeling is that if and when the credit crisis eases, Ambac has no where to go but up. Just last year it was trading in the $90 range. Today it’s at two bucks. Unless it goes out of business, the stock doesn’t have much downside left, although I certainly wouldn’t buy it at this level–not until it and the rest of the banking and brokerage sector shows signs of resuscitation.

Exchange-traded funds, better known as ETFs have exploded in popularity in recent years. They started innocently enough as stocks that tracked the major indices. The first such tracking stock was the Spyders (SPY) introduced in 1993, followed by the Diamonds (DIA) in 1997, and then the Q’s (QQQQ) in 1999. These stocks mirror the price movements in the S&P 500, the Dow, and the Nasdaq 100 respectively. So popular have these stocks become that average daily volume for the Spyders is close to 200 million shares! (It’s 133 million for the Q’s and about 13 million on the Diamonds.)

The tremendous success of these tracking stocks have given rise to a universe of other ETF products. Today, you can find an ETF that mirrors almost anything, including commodities, foreign countries, etc. If there’s a mutual fund for it, chances are good there’s a corresponding ETF. One of the more interesting ETF families that have emerged in just the past couple of years are the short and the ultra-short ETFs. Short ETFs are designed to mirror the exact opposite movement of their underlying index. That means if the underlying goes down by one percentage point, the short ETF will rise by one percentage point. Ultra-short ETFs go one step further–for every percentage point down in the underlying, the ultra-short ETF will rise by two percentage points. These puppies offer a lot more bang for your buck, and one reason they’re now so popular (especially in bear markets) is that anybody can trade them in their IRA accounts. (You don’t need a margin account to effectively short stock.)

One popular strategy in bear markets is to buy the short and ultrashort index ETFs, but I got to pondering the question: What’s the best strategy–buying the straight ETFs, shorting the opposite EFT, or playing their options? And instead of looking at just bear markets, what about bull markets, too?

To answer that question, I decided to look at the Q’s since they’re very heavily traded and have a liquid options playing field. First, I’m going to look at the bearish decline in the Q’s which began when the stock broke major support at $52 on November 8, 2007. This trend lasted until it broke resistance at $46 on April 18, 2008 and began trending higher until just last week (June 11th) when it fell below major support at $48. Okay, so now we’ve got two scenarios: Bear Market from 11/8/07 – 4/18/08 and Bull Market from 4/18/08 – 6/11/08. Let’s compare strategies.

The Strategies
The first strategy is to simply either buy or short the Q’s. The second is to short or buy the QID which is the ultrashort Nasdaq 100 ETF. (Both tracking stocks can be shorted.) The third strategy is to buy calls on the Q’s when the market is heading up and buy puts when it’s heading down. (I wanted to compare options on the QID but there wasn’t enough data–sorry!) In the comparisons that follow, I’ll be using equal dollar amounts of $10,000 each. The prices quoted reflect closing prices and commission costs are not included. Here’s what I found:

Bear Market Comparision (11/8/07 – 4/18/08)
Strategy #1: Short the Q’s.
Short (on 11/8/07): 193 shares @ $51.73/share = $9984.
Cover (on 4/18/08): 193 shares @ $46.71/share = $9015.
Total Gain = $969 for a 9.7% return over the time period.

Strategy #2: Go long the QID.
Buy (on 11/8/07): 258 shares @ $38.64/share = $9195.
Sell (on 4/18/08): 258 shares @ $43.22/share = $11,151.
Total Gain = $1956 for a 21.3% return over the time period.

Strategy #3: Buy shorter term QQQQ Puts.
Buy Jun 50 Puts (on 11/8/07): 25 contracts @ $4.00/contract = $10,000.
Sell Jun 50 Puts (on 4/18/08): 25 contracts @ $3.64/contract = $9100.
Total Gain = -$900 for a -9% return over the period.

Strategy #4: Buy QQQQ LEAP Put options.
Buy 2010 Jan 50 Puts (on 11/8/07): 17 contracts @ $5.70/contract = $9690.
Sell 2010 Jan 50 Puts (on 4/18/08): 17 contracts @ $7.10/contract = $12,070.
Total Gain = $2380 for a 24.6% return over the period.

Bull Market Comparisons (4/18/08 – 6/11/08:
Strategy #1: Buy the Q’s.
Buy (on 4/18/08): 214 shares @ $46.71/share = $9996.
Sell (on 6/11/08): 214 shares @ $47.38/share = $10,139.
Total Gain = $143 for a 1.4% return over the time period.

Strategy #2: Short the QID.
Short (on 4/18/08): 231 shares @ $43.22/share = $9984.
Cover (on 6/11/08): 231 shares @ $41.36/share = $9554.
Total Gain = $430 for a 4.3% return over the time period.

Strategy #3: Buy shorter term QQQQ Calls.
Buy Jun 46 Calls (on 4/18/08): 43 contracts @ $2.30/contract = $9890.
Sell Jun 46 Calls (on 6/11/08): 43 contracts @ $1.75/contract = $7525.
Total Gain = -$2365 for a -23.9% return over the period.

Strategy #4: Buy QQQQ LEAP Call options.
Buy 2010 Jan 45 Calls (on 4/18/08): 12 contracts @ $8.20/contract = $9840.
Sell 2010 Jan 45 Calls (on 6/11/08): 12 contracts @ $8.80/contract = $10560.
Total Gain = $720 for a 7.3% return over the period.

Conclusions
Boy, does strategy choice ever make a difference! I wasn’t sure what to expect and I’m really glad I went through this exercise. Although we only looked at one instance of a bull and a bear market, I think we can safely draw a few conclusions. Compared with the Q’s, playing the QID under both bull and bear market conditions is more advantageous. (You’ll need a margin account to short stocks, though.) But the most interesting results are in the options strategies. Playing LEAPS beats all strategies in both markets. The losses incurred by the shorter term options strategy just shows you how much time decay affects the options pricing, which brings me to my caveat: If you’re planning on holding an option for a few months or so, buy an option with an expiration date that’s at least six to nine months further out. And if you elect to play options, make sure they’re fairly liquid. You can usually buy them at a better price and they’re easier to unload.

If you elect to go the ultrashort ETF route, keep in mind that as your gains are magnified, so are your losses, so it’s best to be very diligent in watching the stock and in setting stop-losses. If you play the Diamonds or the Spyders, you might want to go through a similar exercise. Happy trading!

6/19/08 Added Note: If you want to increase your returns even more, you can trade the index futures. There are now many Emini index futures products that make playing these markets affordable for the retail investor. Because of the high amount of leverage involved, futures can be a very risky endeavor and you can easily lose a substantial amount of money. For more information, contact the Chicago Mercantile Exchange at www.cme.com.

Today we’ll be closing out yesterday’s calendar call recipe by providing an example which will show how the returns are calculated. For this example, let’s look at Microsoft (MSFT). Why did I select Mr. Softie? Not because I think it’s a terribly compelling buy right now, but because it is widely held and has very liquid options. What with Microsoft itching to expand its web presence, it’s not unreasonable to expect that they will be successful and with prudent acquisitions and business ventures, the stock could make a decent comeback over the next couple of years.

Microsoft traded off of its major support level at $27 on June 11th and if we had purchased the 2010 January 25 LEAP call on the day, we could have picked it up around $6.00. The stock has risen since then and looks like it’s heading higher. It has a minor resistance level around $30 and if it bounces back off of that, then I’d look to sell the Jul 30 call.

Return Calculations
Let’s say that Microsoft does exactly that in a week or so. Using my handy Black-Scholes calculator*, the value of the July 30 call will be about $1.00. Let’s compare the return statistics for this trade.

If the stock returns to its $27 support level at option expiration on the third Friday in July, a regular covered call would yield a return of 3.7%, and the calendar call would give a 16.7% return. See the difference? Better yet is the cost of getting into the trade. A hundred shares of Microsoft would have cost you $2700, but one LEAP contract (one contract represents 100 shares of stock) would have cost only $600. You could then apply the extra $2100 to other trades or even use it to buy more LEAP contracts.

The maximum risk you take on the calendar call is the net debit of the transaction. If this is the first time you’re writing a call against your LEAP, then the net debit is the price of the LEAP minus the price of the short call, or $5.00 in this case. As you write more calls, your effective LEAP price is reduced. In fact, if you can successfully take in a buck each time you write a call, you’ll only need six write cycles to break even on your LEAP. This is good news because right now there are no August or September options available. However, they can become available one month prior to the date. But even so, many times these “out of cycle” options can be thinly traded.

What if Microsoft is trading above $30 at July expiration? You’ll be assigned on the short side which means you’ll either have to buy stock at market price or close your spread. Even though you’ll lose your LEAP, you will enjoy a profit since your LEAP will have increased in value. You’ll need your options calculator again to determine the amount of this increase. In this example, my options calculator shows an assigned return of 51.9%. (The annualized return is 412%.)

Conclusion
There are many other return statistics that I haven’t included here such as downside protection and the break-even point. I felt they involved too much math and were of secondary importance, but for those of you who are you really interested in those numbers, you can study them at your leisure on the options links at the top. Now you have an alternative to the standard covered call recipe so be bold and take a LEAP!

*I subscribe to an options pricing program which provides an easy to use options pricing calculator. Some brokerage firms also provide this, so check and see if yours does. Also check the above options links or try a web search for “Black-Scholes options pricing calculator.”

Today I was going to post a recipe using long-term options, otherwise known as LEAPS, but in the middle of writing it up, I felt that a little background is needed first especially if the reader is unfamiliar with them. But LEAPS are worthy of discussion in their own right as they can be used as a substitute for owning (or shorting) stock. If you know LEAPS like the back of your hand, then move on. Today’s discussion probably won’t interest you. But if you’re like many investors whose only concept of going long is to buy stock, then I highly suggest you read on for LEAPS can provide you with a cheaper way of participating in price movement, limit your downside risk, and magnify your returns. Do any of these sound intriguing?

What is a LEAP?
A LEAP is an acronym for a long-term option (Long-Term Equity Anticipation Securities). Of the universe of over three thousand optionable stocks, about a third of them offer long-term options. Most LEAPS have expiration dates set 1-3 years into the future, with January 2010 options currently being the furthest ones available. *

LEAP Calls versus Stocks
Like anything else, LEAPS have their good and bad points.
The Good
1. LEAP calls are much cheaper to own than stocks–some can be as low as 10% of a stock’s face value. This means that if you’re itching to buy a very expensive stock such as Google (currently trading around $570/share) but you can’t afford the $57,000 required to buy a 100 shares, you might consider buying the January 2010 LEAP call at the 570 strike (denoted by 10Jan 570 call) which would cost about $117/contract. Since one contract represents 100 shares of stock, the total you would have to shell out is $11,700. That’s over $45,000 in savings which (if you have the funds) you can use to make other purchases or put in an interest bearing account.
2. Because of the huge leverage that options offer, your profits will be magnified. Let’s take an example. Today, an analyst upgraded Continental Airlines (CAL) with a price target of $22. Although he didn’t specify when he expects the stock to reach that price, let’s say that it will take about 18 months to do it which isn’t unreasonable. You can purchase the stock today at the current price of about $13.50/share, or you can buy the 10Jan 12.5 call option for $4.50/contract. (Talk about a flying LEAP! (Flying…airlines…) Oh, stop groaning.) At options expiration, what will be the difference in returns? Had you just purchased the stock, your profit would be $8.50/share or 63% which is great. But if you had purchased the option, it would be worth $9.50/contract (the stock price at expiration minus the strike price). You’d have netted a total of $5/contract (the option value at expiration minus the initial cost of the option) which gives a total profit of $500/$450 x 100 = 111%. (Commission costs are not included in the calculations.) In other words, you would have doubled your profit with the added benefit of a reduced initial capital outlay.
3. The maximum risk of the LEAPS approach is limited to the cost of the option. In the above example, let’s say that something untoward happens to CAL such as an accounting scandal which causes the stock to lose 90% of its value in a second. The owner of 100 shares of CAL stock just lost $1200, but the owner of the LEAP would have had her loss limited to the option’s cost of $450.

The Bad
1. Options owners are not eligible for dividends nor do they have voting rights. LEAPS on high-dividend stocks are probably not the way to go unless you’re using a put LEAP as a hedge.
2. The price of an option includes time premium, and it’s the time premium which will erode the value of the option (assuming the stock price remains constant). As expiration approaches, time decay becomes especially pronounced which options holders should be aware of. If it looks like your stock isn’t going anywhere for the three or so months before expiration, then selling your option while it still has some time value is the prudent thing to do.
3. Buying LEAP calls is a very bullish strategy. For you just to break even, the underlying stock must be greater than the strike price of the option plus the option’s cost. In the example of CAL, the break-even point would be $13.50 + $4.50 = $18.00/share.
4. You can also lose money even if the price of the stock remains the same through a decrease in option volatility. In one sense, volatility is a measure of how “hot” a stock is. Higher volatility means that more people are interested in it. Buying an option with long-term expectations just after some exciting news has been released is usually not the best time. Wait a few days (or weeks) until the volatility has a chance to settle down.

Timing is Key
You can see that LEAPS offer definite advantages over buying stocks, but as we also saw, they’re not without risk. In options especially, timing is everything. If you’re bullish on a stock and can’t wait to LEAP into it (sorry!), you’re automatically putting yourself at a disadvantage by limiting your returns and increasing your risk. Wait until your stock pulls back to a support level before buying.

Getting the Best Price
How do you know if you’re getting a good price on your LEAP? One way to know is to check out the current bid price against the theoretical price as computed by the Black-Scholes formula. (Actually, there are two pricing methods: one based on historical volatility and the other based on current implied volatility as given by the SIV. The second one usually gives a higher value.) Many brokerage firms provide this information in their options chains. If the bid price is greater than the Black-Scholes value, the option is considered to be over valued. Conversely, if the option is below it, then it’s under valued. (You can use this method to compare options with the same strikes but with different expirations.)

Another way is to compare the chart of the stock with the chart of the option. Is the current price of the option greater than or less than its price on a day when the stock was at a comparable price? Trading at a higher value is an indication that the implied volatility has increased thus inflating the option price. Wait until the volatility stablizes.

The LEAP Put
If you’re long-term bearish on a stock, then purchasing a LEAP put can be a useful substitute for shorting stock. The margin requirements will also probably be much less (check with your broker). The same points apply to puts as calls, but there is one difference: the return for a call is unlimited but the return for a put is capped since the price of the stock can’t go below zero. Good candidates for LEAP puts are weak stocks in sinking sectors.

Summary
Now you know what a LEAP is and how it can enhance your investment returns, but if you still need more information, click on the Options links at the top of the page. Today is just a warm-up for next week’s recipe, Calendar Call Cake. In upcoming blogs I’m also going to see if I can’t find some tasty LEAP candidates for you to snack on so stay hungry!

*Note that LEAPS come with options roots that are different from the roots of their regular counterparts. About 6 months or so before their expiration, the LEAPS root will revert to the normal root. This is just a heads-up so you won’t be confused when you open up your brokerage statement and see a strange looking option symbol on it.