The Underlying Premise
As stated earlier, option premiums do not reflect inflation or the growth prospects of the underlying issue. This does not matter much for standard options because of the relatively short time to expiration—eight months at the most. It does matter, however, for LEAPS, which can expire as many as 30 months later. By not taking inflation or the growth prospects of the underlying issue into account, the level of risk of a put option winding up in the money and being exercised against the writer appears to be larger than it really is. As a result, premiums for long-term put options are often overpriced with respect to the true level of risk involved. As an example, suppose you were considering the sale of an at-the-money put on a stock priced at $100 a share whose volatility was 0.40 and that pays no dividend. The risk-free interest rate is currently 6 percent.
You are considering the sale of a standard put expiring in three months or a LEAP put expiring in two years. Neither premium reflects the earnings growth rate of 15 percent a year forecast for the company. Thus, the effect of earnings growth was to lower the relative chances of financial exposure by only about one-sixth (0.358 ÷ 0.431 = 0.831) for the three-month put but by over one-half (0.153 ÷ 0.310 = 0.494) for the 24-month LEAP put. The analogy isn't quite exact, but I think of this as being akin to selling earthquake insurance to homeowners on the East Coast based on the claim rate in California or health insurance to nonsmokers based on the claim rate for smokers. Yes, there will be claims—earthquakes happen everywhere given enough time, and even nonsmokers get sick—but on a statistical basis there will be far fewer claims from East Coast homeowners and nonsmokers. Or in the case of LEAPS, from the put holders on growing companies.
The Fundamental Approach
From the foregoing premise, it seemed to me that a good investment strategy was to sell LEAP puts on companies whose long-term prospects were so good, and balance sheets so strong, that the possibility of being assigned the stock or otherwise incurring a loss was remote. The premiums received could then be used to purchase more of my favorite stocks. At the time I started doing this, in 1993, the number of long-term LEAPS available was much smaller than it is today. When the CBOE introduced LEAPS in October 1990, it started with calls on just 14 stocks. LEAP puts were first instituted about a year later. By 1993, equity LEAPS were available on only 100 or so issues, about one-third the number that were available by 1999.
In the beginning, I approached LEAP option selection very conservatively. The underlying stocks had to have Standard & Poor's ratings of B+ or better, the exercise prices had to be at least two price intervals out of the money, the expiration date had to be at least 15 months away, and sales were limited to a single contract. In each instance, the underlying issue also had to be a large-cap, blue chip company that, if assigned to me, would fit right into my portfolio of conservative stocks. As time progressed, I relaxed several of these restrictions, selling LEAP puts on stocks with S&P ratings of B or better and expiration dates as close as eight months away, and sales were expanded to multiple contracts. Exercise prices were set at the money if I relished the thought of being assigned the stock and set one strike interval below that if I was more or less indifferent to having to purchase that issue for my equity portfolio.
As a rule, I also try to avoid stocks with volatilities that are extremely low or extremely high. I often calculate the volatility of a stock using one or both of two different methods. The first is by a direct calculation based on the daily price history over the past 12 months. This history is available without charge from many Internet providers (I use America Online), and the calculation is readily performed using the method. The second method is to calculate the implied volatility level that is derivable from quoted option premiums by means of the approach. Stocks with extremely low volatilities will typically have premiums too low to justify the commission and margin requirement involved. Stocks with extremely high volatilities (say 0.75 and above) typically represent issues that are so unstable that the prospects of doubling or nothing (bankruptcy) may be commensurately equal.
This is not to say that you should avoid stocks with moderately high volatilities. In any event, I try to write LEAP puts of such combinations of strike price, expiration date, and volatility that they will generate premiums of $500 or more per contract. I don't always get that, but that is the standard figure I shoot for. By the way, the largest premium I have generated to date for an out-of-the money LEAP put was $3,600 per contract (for the January 2000 LEAP puts, strike $160, at the time Dell Computers was at $180 in July 1997). Larger premiums than this are available on equities with far higher volatilities, such as Internet stocks with little (if any) earnings and little (if any) operating history.
Because of the relatively large premiums involved, I estimated that the net cost (strike price less premium received) of any stock assigned to me would be in most instances less than the market price at the time the option was exercised. That is, suppose a stock is trading for $102 a share and a LEAP put with strike price $100 is written for a premium of $12. At expiration, suppose the stock has fallen ten points to $92 and is therefore assigned. My effective purchase price is thus $90 ($102 less $12), $2 a share below market value. This ignores commissions, but the effects of the latter are not as great as you might think. Whatever commissions are charged for purchase of the stock are going to be offset in good measure by the interest earned on the $1,200 premium (or imputed interest if the premium was used to buy stock) over a period of as long as 30 months.
Margin and Collateral
Although put writers are not going on margin (they are not borrowing money from their brokers to buy securities), they do have to be approved to open a margin account. There is no minimum dollar requirement to open a margin account as such, but brokers will typically require equity (securities and cash) of at least $25,000 and evidence of stock market experience before permitting customers to sell puts. The collateral requirement for writers of at-the-money puts is 20 percent of the value of the underlying stock plus the premium received. (For deep out-of-the-money puts this percentage drops to just 10 percent.)
In the previous example, 100 shares of the underlying equity was worth $10,200 at the time the LEAP put was sold. To enter this transaction, you would have to have at least $2,000 in collateral. The $25,000 in your margin account would in principle be sufficient to collateralize a dozen such contracts. You would not want to do this, of course, because collateral requirements are calculated on a daily basis, and any downturn in the market, no matter how temporary, would result in a margin call. My comfort level if I were a relatively small investor with $25,000 in stock market assets would be the sale of two such put contracts.
In the event that the option was unexpectedly exercised, the $25,000 in the account plus $2,400 in premiums would be more than enough to cover the acquisition cost of the 200 shares of stock at $100 a share that would have to be purchased under the terms of the option contract. As my stock market account grew to an intermediate size of $250,000, my comfort level expanded to a limit of 20 contracts at any one time. With enough time, a large account with $2.5 million would be sufficient to handle 200 contracts comfortably. I hope you succeed in achieving this level.
Selection and Timing
Over the years, I have found that which long-term option contract to enter is much more important than when to enter it. In this sense, dealing in long-term LEAPS employs much the same buy-and-hold philosophy that I have used to purchase stocks. This approach differs markedly from that taken by short-term equity and options traders, who may buy an issue at 10:00 AM and sell it by 2:00 PM, hoping for eighth-and quarter-point increases (or decreases). To adequately describe the intensity of a trading environment is difficult. Suffice it to say that for a trader, news that the kitchen is on fire is an unpardonable distraction.
My approach to the selection of a LEAP put to sell is the same as my approach to choosing a stock. In a certain sense, it is easier to pick a good LEAP option than to pick a good stock because the universe of stocks contains thousands of issues and the screening needed to separate the potentially good ones from the rest can occupy a substantial amount of time. On the other hand, there are 300 or so stocks with LEAPS, and it is easy enough to track their historical performance by creating a hypothetical portfolio and using almost any Internet provider to update it automatically on a daily basis. Although the number of stocks in any one portfolio may be restricted to, say, 100 issues, most providers will permit multiple portfolios.
The purpose of this is not to tell you how to select good stocks—there are plenty of books and other informational resources for that. These include Hoover's Stock-Screener, Wall Street Research Net, Yahoo !Finance, StockSmart, Zacks Investment Research, FinancialWeb, Daily Stocks, and the broad-based services provided through America Online. (America Online is not free, of course, but you have to pay somebody to access the Internet.) The various criteria I bring to bear can be summed up in two questions: (1) Would I buy this stock in its own right for my long-term stock portfolio? and (2) Would I mind having it unexpectedly "put to me" at the net acquisition cost (strike price less premium received) as a result of temporary market conditions and a panicky put holder?
As far as timing is concerned, I follow the same sort of dollar cost averaging procedure used by millions of conservative, long-term equity investors. To minimize the impact of fluctuating prices, dollar cost averaging adherents invest the same amount of money in stocks on a consistent, nonvarying periodic schedule. I follow an analogous procedure by selling the same dollar value of LEAP puts almost every month throughout the year. This procedure means that I do not have to guess whether stock prices are high or low, or whether they are going to go higher or lower over the short run.
Tactical Decision Making
If selecting underlying equities by means of these methods is thought of as strategic decision making, choosing the appropriate parameters of the individual LEAP contracts can be though of as tactical decision making. The three independent parameters are the strike price, expiration date, and number of contracts written. Which to select will depend on how much you are willing to risk (i.e., the chance of exercise and assignment) to obtain a given reward (i.e., the LEAP premium offered). Strike prices can range from deep out of the money to deep in the money.
In addition, there will typically be two or three expiration dates available, such as January 2001, January 2002, and (when opened) January 2003. The number of contracts will depend on the risk/reward ratio, of course, but will more likely be a function of the margin, collateral, and assets needed to comfortably handle the transaction(s) involved. Whether to select a conservative, aggressive, or neutral at-the-money approach to strike prices depends on a number of factors that will be discussed in detail in the chapters to come. In situations where more than one contract for a given equity is being considered, the best position may turn out to be a mix of strike prices and expiration dates.
Selling Puts versus Good-till-Canceled Orders
As I've said, my main objective in selling LEAP puts is to pocket the option premium and let the option expire worthless. In addition to this, I frequently sell LEAP puts when my specific goal is to have the option exercised against me as a way of acquiring stock at a net price significantly below the current market value. In this situation, I select a strike price a few steps higher than the one I would normally use for the pure premium retention play. Naturally, the higher the strike price, the greater the premium received and the higher the chances that the LEAP put will be assigned to me. The strike price so selected is typically one or two steps into the money—but rarely more than this.
If too deep an into-the-money put is sold, the net acquisition cost (strike price less option premium) may not be significantly below the current market value. Although some would say that selling in-the-money puts is a high-risk tactic, it is not very different from acquiring stock using a good-till-canceled (GTC) order at a price pegged that much below the current market value. That is, suppose a stock with a volatility of 0.40 that is paying no dividend sells for $100 today. Assume the risk-free interest rate is 6 percent. Suppose investor A places a one-year GTC order to buy the stock at $92 a share, and investor B sells a LEAP put with strike price $110, expiring in 12 months.
Shows that for a risk-free interest rate of 6 percent and for a stock paying no dividends, the corresponding put premium is almost exactly $18 per share. If the stock closes above $110 (without an intermediate dip), investor B is the clear winner because the $18 premium is retained. If the stock closes between $92.01 and $110 (again without an intermediate dip to $92 or below), investor B is again the winner as his or her effective price will be $92 for a stock worth somewhere between that figure and $110. And if the stock closes at or below $92, then the cost basis for both investors will have been $92 a share and their (unrealized) losses will be close to identical.
In actual practice, investor B will be ahead even in the latter situation for two reasons: (1) the option premium of $1,800 will have been earning interest over the one-year period, and (2) the GTC order will more likely than not have been triggered earlier than the assignment, thereby incurring a larger opportunity (or borrowing) cost on the $9,200 needed to purchase the stock. About the only circumstances in which investor A would come out ahead is if the stock were to temporarily fall to $92 (or below), triggering the GTC order, and then close above $110 without the LEAP option ever having been exercised. Almost everyone agrees that the use of GTC orders at prices pegged below market is a sound and conservative approach to stock acquisition. Selling puts to achieve the same ends can be even more cost effective.
Sometimes Life Deals You Lemons
Over the years there have been few instances when a LEAP option proved unprofitable to me. I do not mean to imply by this that the numerous LEAP puts I sold almost always expired out of the money and were therefore worthless to the option holder. On the contrary, on a certain number of occasions I did have to utilize mitigation procedures in order to preserve my profits and eliminate the potential for exercise and assignment against me. It was often the case that an out-of-the-money LEAP put went into the money along the way because of subsequent price dips in the underlying issue.
On only 6 occasions (out of more than 600 transactions) was I ever required to purchase the underlying issue because an option was exercised against me with months to go before the expiration date. The reason for this is simple: option holders of LEAP puts in most instances have bought them for insurance purposes and hope for recovery and a rise of the stock price to the same extent as the option writer. Under normal circumstances, they will not exercise the right to put the stock to the option writer until close to the end of the insurance period, as the expiration date approaches. In all such instances, however, assignment actually turned out to be a blessing.
That's because the assignment relieves you of the time value component of the then current option premium. A specific example will make this clear. Suppose you sold a LEAP put on a fairly volatile stock such as America Online at a time when the stock price was $125. The strike price selected was $100, the expiration date was 24 months away, the risk-free interest rate was 6 percent, and the volatility was 0.65. Suppose that one year later the price of America Online has tumbled to $80 a share. Ouch! Assuming no change in volatility and interest rate, the corresponding premium of an American-style put with 12 months to expiration, stock price of $80, and strike price of $100 is going to be $31.03 ($3,103 per contract).
The LEAP contract you wrote now commands a premium $7.46 more than what you originally received, and if you were to buy back the put and close the position (without instituting any repair and recovery strategy), your net loss per contract would be $746. Very soon thereafter, the option holder exercises the put and you are assigned the AOL stock for $100 a share. You decide to immediately sell the shares for $80, receiving $20 a share less than what you just paid for them. Taking account of the original premium, though, being assigned has thus transformed the potential loss of $746 into an overall profit of $357 ($2,357 less $2,000) per contract.
Risk Reduction Using Spreads
One way of reducing risk is to set up a hedging strategy. This is particularly useful if you are going to sell LEAP puts on lower-'rated companies or those known to be highly volatile. One strategy I have occasionally used is to simultaneously purchase a LEAP put with a strike price well below the strike price of the LEAP put I was selling. If the same expiration date is selected, this is referred to as a bull put spread. It may not always be possible to do this, however, because of the narrow set of strike prices that may be available (each 30-month LEAP series is ordinarily introduced for just three strike prices: one at the money, one in the money, and one out of the money). If that is the case, the LEAP put purchased with a lower strike price will have an expiration date one year prior to that of the LEAP put sold, a hedging strategy usually referred to as a diagonal put spread.
This short leg of the spread can be subsequently rolled out to match the expiration date of the longer LEAP put whenever that strike price opens up. What this hedging technique does is reduce potential profit and potential loss. Profit is reduced because the net premium received is going to be the difference between the premium received from the sale of the higher-strike LEAP put and the premium paid for the purchase of the lower-strike LEAP put. On the other hand, the maximum amount of financial exposure is reduced from that of the strike price of the LEAP put sold to that of the difference between the two strike prices involved.
Table European-Style 30-Month Put Premiums as a Function of Strike Price
To estimate the costs of lower-strike LEAP puts, the set of tables has been prepared showing the theoretical values for European-style LEAP put premiums. The premiums shown were calculated using the simple Black-Scholes pricing formula for European-style options. We noted that the theoretical premium for a 30-month, at-the money LEAP put for a stock priced at $100 with volatility 0.35 was $14.035 per share ($1,403.50 per contract). Suppose, for example, we hedged the 30-month, at-the-money LEAP put by purchasing the corresponding 30-month LEAP put with a strike price of $80 (assuming it was available) for $6.708 per share. The net profit per contract would be $1,403.50 less $670.80, or $732.70, still a sizable amount.
The maximum potential exposure, however, drops from $100 (without an offsetting LEAP put) to just $20 per share. If the 30-month LEAP put with the $80 strike was not available, you could set up a partial hedge by purchasing an 18-month LEAP put with strike price $80 for just $4.908 a share. The net premium this way would be $1,403.50 less $490.80, or $912.70 per contract. As the expiration date of the shorter LEAP put approached, you could close out both LEAPS, replace the expiring one with a 12-month LEAP put whose expiration date matched that of the original 30-month LEAP put, or let it expire without replacement because the price of the underlying stock was now significantly higher (say 15 percent or more) than its original market value, thus transforming the original at-the-money put into one that was considerably out of the money.
Using Rollouts to Recover
Let's consider again the example when at the time the stock price is $102 a share, a LEAP put with strike price $100 is sold for a premium of $12 a share. Suppose further that as the expiration date had approached, the stock had fallen ten points to $92. Rather than accept assignment, the idea now is to roll the option out and down. The first step in doing this is to buy back the put, thereby closing out your position in the original option. Because expiration is relatively close (presumably a month or less away), closing out the option will cost not much more than its intrinsic value of $8 a share ($100 less $92). To be conservative, suppose this is $9 a share, or $900 to close the contract of 100 shares.
At the same time, you sell a LEAP put whose expiration date is two years away (the rollout) and with a strike price of $90 (the rolldown). Suppose the premium generated from the sale of this replacement LEAP put is again $1,200. The overall effect of this maneuver is to net another $300 ($1,200 received less the $900 outlay) for an overall profit of $1,500. Doing this also gives the underlying stock an additional two years to recover. Note that recovery no longer means coming back to the original $100 level. As far as you, the option writer, are concerned, being at or above $90 in two years is going to be good enough. This process can be continued indefinitely, in most instances, until such time as the stock price stabilizes.
Suppose the premium on the replacement LEAP put happened to be less than the closeout price of the prior LEAP put and is, say, $700. In that situation, the net out-of-pocket cost would be $200 ($700 received less the $900 outlay). This offsets the original $1,200 premium by $200 but still results in an overall profit of $1,000. In rare instances a replacement LEAP put may not be available, a situation indicated by the occasional dashes. (The primary reason this occurs is because of announced or pending mergers and acquisitions that never materialize.) Depending on how you feel about the company and its prospects, the simplest thing to do under these circumstances is to close out the option or accept assignment.
This situation has never happened to me. It is possible, of course, to incur a loss as a result of writing a naked put. The worst-case situation theoretically is where the stock price falls to zero as a result of bankruptcy or total financial catastrophe. It would be a truly unusual circumstance if one of the big-cap firms underlying almost all LEAPS went out of business, however. For a big-cap stock, a more credible worst-case situation might be a 25 percent decline in stock price as a result of a general market correction (in the unusually sharp correction of October 19, 1987, the market fell 22.6 percent).
If the price of the stock in our example thereby fell from $102 to $76.50 and the stock was assigned to you at the strike price of $100, the immediate financial exposure would be the strike price of $100 less the market value of $76.50 plus the premium of $12, or $11.50 per share. We see that by immediately writing a near-the-money LEAP put with a strike price of $75, we would expect to receive a premium of about $10 for an expiration date 24 months away (0.75 × $13.314 = $9.99). If this were done and the stock didn't decline further, the overall loss would be $11.50 less $10, or just $1.50 a share. This potential loss of $150 per contract under the circumstances described is small in comparison to the potential benefits.
A Double-Glove Approach
Medical or rescue workers facing uncertain situations often put on an extra pair of gloves for added protection. Analogously, it is possible for you to do the same when future prospects or other market conditions are not as strong as you would like. To ensure double protection in selling LEAP puts, you can sell a put that is at least one strike interval below the at-the-money level and then additionally hedge by purchasing a LEAP put that is several strike intervals below that one. The premiums can still be significant.
Suppose the stock price is $100 a share. If you were to sell a LEAP put with strike price $95 and buy one with strike price $80, your net premium would be $1,192.50 less $670.80, or $521.70 per contract. Your maximum financial exposure would now be $95 less $80, or $15 per share. This double-glove approach is my favorite one in those marginal situations involving stocks with higher volatilities and/or lower ratings that might have otherwise been eliminated from consideration.
There is yet another method of protecting option positions that is theoretically available, namely the use of stop and stop-limit orders. For call or put option owners, a stop sell order is an instruction to the broker to sell (thereby closing) a position at a specified price or at the best price below it if it is unavailable. A stop-limit sell order is an instruction to sell (thereby closing) a position at a specified price and no other. For call or put writers, a stop buy order is an instruction to the broker to buy (thereby closing) a position at a specified price or at the best price above it if it is unavailable. A stop-limit buy order is an instruction to buy (thereby closing) a position at a specified price and no other.
As an example of a stop buy order, suppose you had written a LEAP put for a $10 premium and would like to buy it back and close your position if it goes to $12. If you entered a stop-limit buy order for $12 and the price jumped from anywhere below $12 say, to $12.25, your transaction would not be executed. If you had entered a stop buy order for $12, under the same circumstances your position would be closed out for $12.25. The use of stop buy or stop-limit buy orders seems at first blush like an ideal way to hedge against an unanticipated move in the wrong direction (downward) for LEAP put writers. The difficulty is in the execution. Although all four stock exchanges that handle listed options permit the use of stop and stop-limit orders, as a matter of course most brokerage firms will not accept option stop orders or stop-limit orders from individual customers.
One reason commonly cited by brokerage houses for this is the fact that the rules for option stop orders and option stop limits vary from exchange to exchange.* Another reason is the inability of in-place computer software and communication systems to reliably handle the complex instructions that must be wired to the trading floor. Stop buy and stop-limit buy orders are everyday occurrences on the stock exchanges but are typically done on behalf of institutional investors or those having direct links to the floor traders. There is another reason I prefer not to use stop orders or stop-limit orders (even if I could readily do so).
Over a multiyear period, the steady earnings growth of a solid company will result in a stock price movement up and away from the specified strike price. However, it is quite possible to experience a short-term price decrease in the underlying stock because of normal volatility in the equity markets. Once stop and stop limit orders are triggered because of a temporary downturn in stock price, it is not possible to capitalize on the eventual recovery in stock price and the associated erosion in the LEAP put that was in all likelihood going to expire worthless. One more reason I don't like to use stop orders is because they are executed in a different manner for options than for stocks.
Suppose you owned a stock that had a bid price of $10 and an asked price of $10.25, and you submit a stop loss order at $9 to protect your position. If the bid/asked falls to $9/$9.25, your trade will be executed because the price you want to sell at matches the bid price offered by buyers. This would not be the case if the same situation involved an option, however. By the rules of the game, your $9 stop loss order would not go off until either the asked price reached $9 (in which case the bid might be $8.75) or a trade went off at $9, whichever occurred first. The analogous situation holds with respect to stop buy orders. Difficulties in trying to explain all this to customers may be the real reason brokerage houses will not accept stop orders on options.
Timing the Market
There may be individual investors who are good at timing the market, but I am not one of them. For this reason, I adopted a long-term, buy-and-hold approach to stocks and a regular, almost dollar cost averaging, approach to acquiring stocks during 30 years of investing. I have tried to adopt this philosophy with regard to options activity, selling just a few LEAP puts per month throughout the year rather than attempting to jump in and do it all during the three-month window in June, July, and August, when the new round of LEAPS is being established.
On the other hand, I do not ignore market conditions. When the market is especially volatile, I will often hedge by selling LEAP puts that are further out of the money than I would otherwise. Doing this is especially useful when the market appears overbought and a market correction appears possible. Of course, if such a market correction appears likely, I usually suspend selling LEAP puts and adopt a wait-and-see approach.