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Let's say I am bullish on company XYZ at the current price. I feel like they will go up long term, and are priced well.

I can sell a PUT on XYZ at a lower price than it is currently trading (i.e. out of the money), and "win" either way: if the stock doesn't drop down, I collect the put premium on expiration, and "do it again"; if the stock drops down, I collect the put premium and get to own XYZ at an even lower price (than if I had bought it at the initial price).

Now, while I like this strategy, I also like to own leaps (calls) deep in the money on stocks, instead of owning the stock outright. I'm able to get more leverage than buying the stock outright, and it allows me to get rid of short term risk / fluctuations in the price of the stock.

The question is, can I do the same thing as above, selling ?, and if the stock price drops, have the leap assigned to me. What is it I could sell, and what would be the mechanism to get the leap assigned to me?

Thanks

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I understand what you're asking for (you want to write options ON call options... essentially the second derivative of the underlying security), and I've never heard of it.

That's not to say it doesn't exist (I'm sure some investment banker has cooked something like this up at some point), but if it does exist, you wouldn't be able to trade it as easily as you can a put or a LEAP.

I'm also not sure you'd actually want to buy such a thing - the amount of leverage would be enormous, and you'd need a massive amount of margin/collateral. Additionally, a small downward movement in the stock price could wipe out the entire value of your option.

  • Thanks Daniel. I'm not sure why you say the leverage would be enormous. All I want is a LEAP put to me (end up with that), just like one can end up with a stock put to them (at a lower price) than it is currently trading. – Ray K Oct 11 '11 at 16:20
  • Let me give you an example. Today AAPL went up 3%. The $400 AAPL Call (Jan 12 2011) went up 20%. If there were a $25 AAPL LEAP Call, it would have gone up significantly more than 20% (maybe 100%?). Do you see how and why your leverage increases as you add layers of options? – Dan Carroll Oct 11 '11 at 21:54
  • Thanks Daniel. As one goes deeper in the money, one pays much more for the leap, but the time value one pays goes to zero. As such, one wouldn't make that much on a $25 LEAP, since its price would be nearly the price of the stock. The leaps I'm looking at are the $260 Jan 19 2013, because they have almost no time premium (percentage wise), and are about 1/3rd the price of owning the stock outright. Indeed, if one had a 5% interest bearing account to put the savings into, this option would be safer/return better than owning the stock, esp if stock went to $260; sell leap, and get time prem. – Ray K Oct 12 '11 at 3:17
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I can sell a PUT on it a bit out of the money, and I seemingly "win" either way: i.e. make money on selling the PUT, and either I get to pick up the stock cheaper if XYZ goes down, or the PUT expires worthless.

In 2008, I see a bank stock (pick one) trading at $100. I buy that put from you, a $90 strike, and pay you $5 for the option. The bank blew up, and trades for a dollar. I then buy the $1 share and sell it to you for $90. You made $500 on the sale of the put, but lost $8900 when it went bad. You don't win either way, there is a chart you can construct (or a table) showing your profit or loss for every price of the underlying stock. When selling a put, you need to know what happens if the stock goes to zero since the odds of such an occurrence is non-trivial.

A LEAP is already an option. With the new coding scheme for options, I'm not sure there's really any distinction between a LEAP and standard option, the LEAP just starts with a long-till-expiration time. There are no options on LEAPS that I am aware of, as they are options already.

  • Thanks Joe, I hear what you're saying. I mean, if I like company XYZ at the current price, because I believe they have a good future, I should be happy to be able to pick them up at a cheaper price. That's what I mean by win if the put is excercised (get company I like cheaper), or win if its not excercised (collect the premium). I'll see about rewording as requested. Thanks. – Ray K Oct 10 '11 at 22:17
  • Sure, Ray, and it often works just like that. But, the set up is unique. And you'll have an adverse response if the stock shoots up (for having not bought any) or if it really tanks, as did the 'safe' banking stock in my example. You only end happy if the stock trades pretty flat or just low enough to be assigned the shares, in which case you got the discount of the put premium. – JoeTaxpayer Oct 10 '11 at 22:30
  • Joe - I reworded the question. Since the put premium on volatile stocks is quite high, I make a significant income (a few percent) right off the bat. Since generally stocks fluctuate, I'm able to often pick it up again; well, in fact, if it goes up mildly or stays more flat, I can just sell the put again. Make more money, until its assigned (when I can then sell covered calls). – Ray K Oct 10 '11 at 22:33
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There are options on options. Some derivative instruments assets ARE options (some ETFs), and you are able to buy shares of those ETFs OR options on those ETFs.

Secondly, options are just a contract, so you just need to write one up and find someone to buy the contract. The only thing is that the exchange won't facilitate it, so you will have liquidity issues.

What you want to do is a diagonal / calendar spread. Buy the back month option, sell the front month option, this isn't a foreign concept and nobody is stopping you. Since you have extra leverage on your LEAPS, then you just need to change the balancing of your short leg to match the amount of leverage the leaps will provide. (so instead of buying,selling 1:1, you need to buy one leap and perhaps sell 5 puts)

  • Thanks. Very interesting. This seems a little different though, as I'm not getting the "LEAP put to me." E.g. if a LEAP I'm looking at has 3:1 leverage, and I buy the LEAP and sell 3 front month puts, then if the stock does drop near term I end up with 3 shares at a lower value, and a LEAP at a lower value? – Ray K Oct 11 '11 at 16:10
  • okay, if you buy a LEAP call (bullish) and sell 3 front month puts (also bullish), if the stock drops near term your puts will gain value very quickly (I hope you have A LOT of margin), but upon the front month expiration you will be 300 shares short. If you exercise any stock option you will have 300 shares. You might want to look into selling front month calls instead to hedge your longterm bullish position. – CQM Oct 11 '11 at 16:31
  • Hmm. I guess I could sell a PUT @38.00, when the stock is at $40 (and collect the premium). Then, if the stock drops down to $37, it will get it PUT to me, at a price of $38. I could then sell it at $37 (losing the $1), and buy a deep in the money LEAP (with little time premium). Then, I could sell front calls at some profitable dollar point, that ideally would not get excercised. Not sure this makes sense $-wise, but seems closest. – Ray K Oct 11 '11 at 18:30
  • its called assignment, it gets "assigned" to you, not "put". anyway this sounds like a bad strategy as you could go insolvent before expiration, a gap down would obliterate your account. – CQM Oct 11 '11 at 19:36
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There are many stategies with options that you have listed. The one I use frequently is buy in the money calls and sell at the money staddles. Do this ONLY on stocks you do not mind owning because that is the worse thing that can happen and if you like the company you stand less of a chance of being scared out of the trade. It works well with high quality resonable dividend paying stocks. Cat, GE, Mrk, PM etc. Good luck

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As with most strategies there are pros and cons associated with this approach:

Advantages of using LEAPS:

  • Less costly than purchasing stock; remaining cash can be used to generate additional cash
  • A declining stock will have time to recover
  • Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.

Disadvantages of using LEAPS:

  • You do NOT capture stock dividends
  • To stay active, you must sell options in cycles that report earnings, taking on additional risk
  • LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
  • A higher level of approval will be required by most brokerages to allow this type of trading
  • The long calls will ultimately expire, stocks will not
  • Forced assignment may not allow for a profitable trade

Read more about it in great detail on my blog:

http://www.thebluecollarinvestor.com/leaps-and-covered-call-writing-2/

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    Again, good articles are appreciated. As I said on the other, our community generally agrees that we should excerpt relevant portions of the article in addition to the link. An answer should stand on its own. Citations are great, but the answer needs to be here. Thanks! – MrChrister Jul 5 '13 at 18:20

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