When most people hear the word options, they put their hands on their wallets, and when they feel reassured that its still there, will turn and run. Despite the rumors heard by the general public, trading options can actually be a relatively safe prospect, and profitable too. The fact that most traders are afraid to delve into this arena of trading can provide you with a good niche to make profits. That niche is LEAPS. Before we talk about what a LEAP is, you first must know how an option works. What is an option? Well when you buy an option it gives you the right (the option) to buy or sell something at a certain price by a certain date in the future. Huh? You say? It's simple. Say your uncle has a corvette to sell, and you don't have any cash. You have a buddy from high school who has talked about that corvette all the years you were growing up, and you know he would want to buy it. So you tell your uncle you'll buy the car and put a deposit down to buy it for 20 grand before two weeks are up. Now don't let that big number scare you. You don't have the 20K but it doesn't matter. That’s the beauty of this. You tell him you'll give him $1,000 deposit to purchase the car within the two weeks. If you can't get the money together in two weeks, then he keeps the $1,000. But, you say, I don’t want to lose the $1000 so give me a receipt for this deposit and make it transferable. What this means is that whoever holds the receipt has the right (option) to buy (call) the car for 20 grand (strike price) before the two weeks is over. Now you go to your buddy and tell him you'll sell the receipt to him for $1500 dollars (ask). He says forget it, I'll pay you $500(bid) for the receipt. You, of course will lose money on the deal, so you say you'll think about it and see if you can sell it to someone else to at least get a your money back. You know if you don't sell it in two weeks (expiration) you'll be out of the 1K completely. Now, for the sake of argument , say, that a week later a container ship that just happens to hold thousands of collectable corvettes sinks on it's way to a car show in Japan. The price of collectable corvettes suddenly jumps and your friend calls you up and offers $2000 for the receipt(bid) You've heard about the disaster too, so you say, no make it $2500(ask). Deal. You’ve just made $1500 profit on a $1000 investment. Pretty good. That’s how options work. The price of the underlying instrument varies (the car), and so does the option (the receipt). So what’s a LEAP? It's merely the same thing as an option, but with an expiration of a year or two in the future. It's true that most options are traded by the pros, who extract their profits by posting a wide spread between the bid and ask price, as well they should. After all they are the one's providing liquidity to the market. So, that being said, options aren’t something you want to flip a lot, merely because that’s where the brokers make their profit, and where the buying public loses in the long run. If the underlying instrument doesn't move much at all in the time period before expiration, then you've lost your dough. This is true for the majority of options (most of them expire worthless). Now, there are many many programs and options hucksters that evaluate options for their implied volatility vs. historical volatility, put /call ratios, squeeze plays, blah blah blah, all playing on the fact that there may be a sharp rise or fall in the price of the underlying instrument in the short term, and thus making a profit. But that's risky and takes some serious number crunching programs. We won't be looking at that. So how does a LEAP fit in? The fact that it has a long expiration does make it more expensive that a shorter term option, but it's still cheaper than the stock you would buy. Say for example a stock called ABC is selling for $65. The option to buy (call) the stock at $70(strike) which expires in one month will cost, say $230. That gives you the right to buy 100 shares of ABC at $70 bucks within the next month. If, in the next month the price of the stock jumps to $75, well, you’ve just made $5 a share, or $500, well over 100% profit. Now the same strike price for a year in the future will cost about $1100(these are actual prices of a stock I'm looking at). Ok, way more expensive. Why would you want to do that? Here's why. It's a known fact that most options expire worthless. So, a smart trader, (like you, since your reading this instead of watching TV) would think, hmmmmm, maybe I should sell these options and make money that way. Yes, you can do that. (It's called writing options by the way) But it's extremely risky. Say you don't own the stock and you sell a $6 call option (each call gets you the option to buy 100 shares) for a little known biotech firm that sells for $5. It hasn't moved for months and you’re sure it won’t in the future. Your buyer pays $.5 for it and you get $50(.5 x 100 shares, the standard lot size). Not a lot, but hey, it's money. The thing is, though, you have to cover that call until expiration. So if the FDA announces that it jut signed a contract with this little company to produce a vaccine and the price jumps to $50 a share before expiration, you have to cover the difference ($4,400). If the announcement happened the day after expiration, you keep your $50. Why in the world would you want to do that, you ask yourself? You wouldn’t. The safer way to do it is to buy the stock at $5 a share, and simultaneously sell your $6 call option for $50. You just paid $450 for your 100 shares while the rest of the schmucks out there just paid $500. You saved %10. And now when the FDA makes the announcement your not worried because you can sell the stock to cover the call option you sold and still keep your $50 premium, no sweat. Cool huh? The problem here is most reliable stocks don't sell that cheap. So you'll have to fork out 5 large to buy 100 shares of a $50 stock, only to make a few hundred when you sell the call (by the way, this is covered call: when you don't own the underlying equity, it's called a uncovered, or naked, call). A better way is to use a LEAP. Here's how. You buy your LEAP with a strike of $55 for $1100. Way cheaper than the 5 grand you would pay for the stock. It expires in 1 year. The stock trades right now for $50. Now you can sell your one month $65 call and still be covered. (Technically speaking this is called a calendar debit spread). If the price of the stock goes up, you have your leap option to back you up, and you still have the premium from the option you sold. Now, here’s where it gets real fun. A month later, the stock hasn't moved much, and the original call you sold expires. You keep the premium. Now you sell ANOTHER 1 month call option. Sweet. Over and over. That’s how you make money with this stuff. Ok, to back up a minute, imagine you can buy an option to SELL a certain stock at a certain price at sometime in the future. Say if a stock trades at $40, and you buy an option to SELL the stock at $35 before the month is out, and the thing tanks to $30 before then, that means you have the right to SELL it at $35, regardless of what the current price is. You've just pocketed a grand. sweet. That’s called a PUT. You buy a PUT just like you buy a CALL. LEAPS can be bought in a PUT form too. Now you've got the power to harness money making machine, because you can make money when the stocks go up, when they go down, and when they don't move at all. What other way can you make money in the markets in all these situations? None. You heard it here first. Paul Nickel is a active trader and avid poker player, and you can gain more knowledge of each of these areas at http://www.lowrisktrading.info and http://www.poker-cash.info
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