"LEAPS are Evil"
Tuesday, October 10, 2006 at 01:14PM
I wrote the title in parenthesis since I am not taking the credit for said statement. I am willing to look at both sides of this coin though. I will start with the strategy in general and then come back to this quote. Bear with me...
Does anyone out there trade LEAPS? If so...WHY? I will take the role of a critic now and criticize any LEAP option traders. I can see the reasons someone would use to explain why they trade them....
LEAPS are supposed to be long term options, right? This means we hold them over long periods of time in order to capitalize on longer term trends, etc. I would wager a bet that not one trader out there who trades LEAPS has held on to one longer than 2 months. Despite having anywhere from 7 months to 2 years I would be surprised to see that someone has help a LEAP longer than two months. If you have held one longer than two months, I will double down that you have not done it more than once.
Am I Right?
Like I said, floor traders discount all methods of technical analysis. This includes the three premises all technical analysts live and die for...
By increasing Implied Volatility for each extending month, this creates a larger premium for you to pay. The lack of activity creates huge spreads, and I was told that the maker knows that the order coming through is a retail order. Apparently institutional money doesn't trade LEAPS.
As I asked more questions, this gentleman claimed that one should never buy more than 150 days of time. This makes sense to me. This is what I teach. I have always suggested trying to gauge how much time you think you need, buying a little extra, and getting out after the stock has made your move. While I do not promote buying too much time, buy a little more than you were expecting to use. Just in case.
To tie this together, I don't have anything against LEAPS. But I do have something against the trader that buys them, and doesn't really use them. If I were you I would buy less time and get more contracts if you are the trader that doesn't take full advantage of them.
By the way, let's not go in the direction of "What if my strategy would be selling covered calls against my LEAPS" because those little premiums don't absorb the stock losing significant portions of it's value. When you start selling strikes lower than the strikes you purchased, you are in a bear spread.
I think I am done for the day, see you tomorrow.
Does anyone out there trade LEAPS? If so...WHY? I will take the role of a critic now and criticize any LEAP option traders. I can see the reasons someone would use to explain why they trade them....
Leverage
"It's like owning the stock at a discount!"
Follows the stock closely (1:1 Delta)
More time until expiration...One day it will be profitable!!!
LEAPS are supposed to be long term options, right? This means we hold them over long periods of time in order to capitalize on longer term trends, etc. I would wager a bet that not one trader out there who trades LEAPS has held on to one longer than 2 months. Despite having anywhere from 7 months to 2 years I would be surprised to see that someone has help a LEAP longer than two months. If you have held one longer than two months, I will double down that you have not done it more than once.
Am I Right?
Why is this? Why would you trade LEAPS when you are not taking advantage of them? It is supposed to be the same approach as trading stock is. Intended for longer term holding through longer term trends, offers leverage, and offers you a discount to purchasing the stock. Have you looked at the price of the premiums? Let's use an example. Assume I love Apple Computers. Let's say I want to buy the first available LEAP. I would be looking at Jan 08's. To get 1:1 movement with the stock I would take the 50 strikes. They offer a delta of .888 which is close to .89, which gets rounded up to .90, and that puts us where we want to be. These options cost $29.40!
I can tell you that I know enough about my myself not to take a trade that doesn't offer me an advantage. I know that I could never hold a trade that long, so I don't trade LEAPS. Ask yourself, if you are not going to use the full amount of time until expiration, why would you pay for it?
Let me get back to the comment I heard the other day. I have been spending time learning the ways of the floor trader, and how they discount all analysis but price movement and probability. As I talk to this gentleman about his experience in the trading pit, we start to talk about LEAPS, and then this comment surfaces.Like I said, floor traders discount all methods of technical analysis. This includes the three premises all technical analysts live and die for...
Market Action Discounts Everything
Prices Move in Trends
History Repeats Itself
As I started to dig deeper I could see that this comment was based solely on price structure. Which makes complete sense. Can you really put a price tag on that much time? A market maker can't...there is not enough liquidity or enough of a market to make an efficient price structure. Take a look at how they compensate...(Click to view larger image)
By increasing Implied Volatility for each extending month, this creates a larger premium for you to pay. The lack of activity creates huge spreads, and I was told that the maker knows that the order coming through is a retail order. Apparently institutional money doesn't trade LEAPS.
As I asked more questions, this gentleman claimed that one should never buy more than 150 days of time. This makes sense to me. This is what I teach. I have always suggested trying to gauge how much time you think you need, buying a little extra, and getting out after the stock has made your move. While I do not promote buying too much time, buy a little more than you were expecting to use. Just in case.
To tie this together, I don't have anything against LEAPS. But I do have something against the trader that buys them, and doesn't really use them. If I were you I would buy less time and get more contracts if you are the trader that doesn't take full advantage of them.
By the way, let's not go in the direction of "What if my strategy would be selling covered calls against my LEAPS" because those little premiums don't absorb the stock losing significant portions of it's value. When you start selling strikes lower than the strikes you purchased, you are in a bear spread.
I think I am done for the day, see you tomorrow.
Reader Comments (6)
I PERSONALLY AGREE WITH YOU.
ROCK ON!!! STEVE L
I absolutely agree with you on analysis of LEAPS! I was thinking about this myself.
And yes you are right, I bought LEAPs on GG but only held onto to them for 2 months!
If I ever buy LEAPs again it would be to employ a calender spread strategy to pay for the trade over time. I am not sure I would have the patience to hold a trade for that long though.
Thanks for the elightenment
John
I am learning how the market makers (mms) trade. It is really interesting to see that it seems like the mms are ahead of the game versus the retail investors. For instance, I learned that around Friday noon mms quote the options with the weekend time decay already on them. So if you were only trading friday for the weekend time decay, you'd be out of look since it is already factor into the market.
Jake H.
Hal