Dan Sheridan provides some guidelines and offers alternative ideas.
Leap calls have some key differences when compared to shorter term calls. Understanding these characteristics is absolutely necessary to be successful in the markets. Implied volatility is my biggest concern by far. Most retail traders think the only enemy they have to a leap call is stock price, but implied volatility is just as big a foe. Another one is how to choose which strike to buy. In this blog, I will take some time to address these factors, plus offer a couple other alternative strategies to make sure you have the proper knowledge before heading into combat.
If you need more information, please read Play#1 in the online version of The Options Playbook located in TradeKing's Education Center. You may also want to read up on Play #19 - the Long Call Butterfly and Play #29 - Diagonal Spread with Calls. Both of these plays explained below are slightly different than the versions in The Options Playbook. However reading these sections would be time well spent.
THE PLAY - LONG CALL
TRADE FORMATION
On July 18 at 9:39am, Community member Casey entered the following:
Strike A: Bought to open 8 Citigroup Jan 2010 27.50 calls (WRV AS) for $1.50
Stock at entry: Citigroup near $19.80
Long call entry: $1.50 debit
Maximum gain: theoretically unlimited
Maximum loss: $1.50 debit
Break-even point at expiration: $29 (Strike A + debit paid)
On July 24th at 11:34am, Casey closed the position:
Strike A: Sold to close 8 Citigroup Jan 2010 27.50 calls (WRV AS) at $1.80
Stock at exit: Citigroup near $20.00
Long call exit: $1.80 credit
Trade result: $0.30 profit (exit - entry) (before transaction costs)
Return on investment: 20% (before transaction costs)
*NOTE: This return represents past performance and does not guarantee future results.
ALL STAR COMMENTARY
Casey basically did a very good job of trading a leap call in Citigroup. The stock closed under $15 per share for the first time on Monday, July 15th. It then rose to about $19.50 on the morning of July 18th. Casey had seen enough. He's a trend trader; the Citigroup recovery train was leaving the station, and he bought a ticket. Moving ahead to Wednesday, July 23rd, Citigroup was up again, now over $21. The January 2010 27.50 calls he bought for $1.50 were now trading around $2.10 (up 60% in 5 days!). By the end of the week on July 25th Citigroup traded back down under $19. The call gave some back and was now $1.70 (up only around 15%). Deciding not to ride it out longer term, Casey exited and went home with a solid gain of 20% before costs. My hat's off to him, but is there room for improvement? There are two factors I would like to mention that strongly impact a trade like this - time horizon and strike.
Let's start with time. Casey's time table was about 18 months, so leap calls were an appropriate choice for a long term portfolio. If I thought Citigroup would rally as fast as it did or even over two months I would have probably gone with much shorter term calls.
What about strike? Should he have bought an in-the-money, at-the-money or out-of-the-money strike? Implied volatility is something I look at closely when determining which one to buy. When Casey bought the leap call for $1.50, the implied volatility was around 44. (See image below). This was near the middle of the implied volatility range over the last year, which is higher than I would like it to be for a trade like this. To read more about implied volatility analysis, check out Dig out your Ginsu Knives by Nicole Wachs.
Now let's talk about vega for a moment. The vega was 7 cents. If the implied volatility was at 40 (4 points lower), the call would be around $1.20 (vega of .07 x 4 point decrease in volatility, deducted from $1.50). When implied volatility levels are relatively cheap, I might consider buying ATM leap calls. When implied volatility levels are high, I would go deeper ITM with my leap call purchases because ITM calls have less vega than ATM calls. Another way to reduce my vega risk is to use a shorter term call, again because the vega amount is lower. Shorter term calls have less vega than longer term calls at the same strike. In both cases, if implied volatility drops, I would lose less per volatility point. To learn more about this, read Brian Overby's series on this very important greek.
Click here for a larger image.
Besides a drop in implied volatility, another event that can spell trouble for an OTM leap call purchase is if the company is taken over or enters into a merger. This is because these calls are all time premium. In a merger these premiums can decrease quite a bit or disappear entirely if the stock is taken over below the strike purchased. Ouch!
You may be wondering would I have used an alternative strategy here? Possibly. The call purchase by Casey was pretty good. He spent around $900 for 8 Jan 2010 27.50 calls which was a good bang for his buck. Here are a couple others to chew on with less vega risk. The first one is what I call a "Time Bomb Butterfly" and the second one is similar to a covered call, but uses a leap call instead of owning the stock.
Butterflies are typically neutral strategies. However the point of max gain is always the center strike. If you need the stock to move considerably to get to the middle strike, the butterfly becomes either bullish or bearish. In this case, since Citi was $19.50 and the center strike used was 25, this butterfly is bullish because the stock needs to increase for this play to make money.
Alternative strategy #1 - "Time Bomb Butterfly" in December
On July 18th with Citigroup around $19.50, the Time Bomb Butterfly set up like this:
Strike A: Buy to open 5 Citigroup December 22.50 calls
Strike B: Sell to open 10 Citigroup December 25 calls
Strike C: Buy to open 5 Citigroup December 27.50 calls
Butterfly entry: $0.36 debit
Maximum gain: $2.14 (Strike B - Strike A - debit) x 5 x 100 = $1070
Maximum loss: $0.36 debit x 5 x 100 = $180
Break-even points at expiration: $22.86 (Strike A + debit) and $27.14 (Strike C - debit)
Click here for a larger image.
Over time as we get closer to December expiration, and if Citigroup moves toward the sweet spot of $25 (Strike B) this spread could increase to a maximum of $1070. This spread also benefits from a decrease in implied volatility which usually results as the stock increases.
In the next strategy, we are buying a deep ITM leap which mimics the stock in a covered call. The call we are selling becomes our short term target. The goal is to be able to sell the call and have the stock rise slowly.
Alternative strategy #2 - Diagonal ITM Calendar Spread
Click here for a larger image.
On July 18th with Citigroup around $19.50, the Diagonal ITM Calendar Spread would look like this:
Front-month higher strike: Sell to open 2 Citigroup August 20 calls
Back-month lower strike: Buy to open 2 Citigroup January 2010 12.50 calls
Diagonal spread entry: $7.50 debit
Maximum gain: approximately $1 in first month
Maximum loss: $7.50 debit
This strategy would give me 16 months to sell premium against my long leaps after August expiration passes. This allows us to hold a long leap call, but at the same time we can reduce our cost basis as we sell each month. As a rule of thumb, when time premium of our short option gets under $0.20, I would roll up one strike (if possible) and out one month. Rolling up gives the stock room to increase over time. Brian also has a series on rolling. Click here to read more.
Conclusion: The main thing with any strategy including leap calls is a plan.
1. When will I take profits on some or all of the calls?
2. When will I take a loss?
3. When will I adjust?
With these calls, if I asked Casey if he would take a 60% profit in 5 days, what would he say? It was on the table. All these things need to be decided ahead of time. Have limit orders or contingent orders in place if your targets are hit. You prepare for war in a time of peace.
Owner and Mentor
Dan's previous posts: Strangle Guidelines for Momentum Stocks and Stugots Weathers Storm with Large Gain
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were prepared on 7/29/08.
Nicole Wachs contributed to this blog.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Dan Sheridan has a professional business relationship with TradeKing.
