Stock options are excellent speculative vehicles -- and the inexpensive, undervalued ones can give you an outstanding bang for your buck.
When you buy cheap puts and calls, they have the potential for unlimited upside if the stock trades in your favor, and the good news is that your losses are capped at the amount you invested. So, when you invest a small amount of money in call option or put option trades, it's the most you can lose!
You can also trade options as a replacement for buying stocks, which can give you far more leverage and help you to incur less risk as you participate in the stock market. This strategy can protect you from the risk of a stock market crash, as long as you don't go overboard.
To use options as surrogates for stocks, you must typically purchase in-the-money calls (that is, when the stock is trading above the option's strike price) that have minimal time value.
Time is crucial with options -- the more time your option has to move into the money -- or deeper in-the-money -- the more valuable it becomes.
But in-the-money options are expensive to purchase, and a big drawback to this trading technique is that if the stock experiences a sharp correction, much of your premium can collapse in a short amount of time.
Although you can't stop the clock, you can always buy more time.
To gain some protection against short-term market events that can impact your hard-earned premium, you can buy out-of-the-money long-term options (also called LEAPS) to take advantage of time value.
LEAPS are long-term options that can last for up to two and a half years, so this can be the next-best thing to owning a stock for a brief, defined period. In fact, many traders end up holding LEAPS for longer than they own stocks!
They are no different than a regular short-term option; the only "real" difference is that, when they come closer to expiration, their ticker changes and the LEAP ticker is reassigned to the next cycle.
For example, Netflix (NFLX) LEAP options in even years (2010, 2012, etc.) start with the root symbol WHU, which means that the NFLX Jan 20 LEAP Calls that are set to expire in 2010 have a ticker of WHUAD.
The WHU root symbol once belonged to January 2008 options, which became QNQ before those options expired. So, those NFLX Jan 20 Calls automatically became QNQAD in the trading accounts of those who hold them.
And in the next even-numbered year, 2010, the same process will take place and the same tickers will come onto the board again, provided that the company is still in business and its stock is trading in roughly the same area.
There's no work that needs to be done on the part of the trader when a LEAP symbol converts, but the reason the ticker has to change is so the currently active LEAP root symbol can be assigned to the series that is two years away from expiration.
After the conversion takes place, if someone would buy an option with the WHUAD ticker, they would be purchasing the NFLX Jan 20 Call -- the one with an expiration date of 2010, 2012, 2014, and so on, depending on when the option is purchased.
Particularly in the summer when the newest option series (i.e., two years out) appears on the board, you should be paying close attention to the options you're buying to ensure they're the right ones!
This extended period of time helps the option premium hold up better during a stock decline, whereas a nearer-term option (i.e., one set to come off the board during the coming expiration cycles) has less of that precious time value and therefore would have less chance of making a recovery. The LEAP, however, allows plenty of time for the stock, and thus the option, to regain its value and even charge ahead to higher highs.
However, a LEAP is more expensive than a shorter-term option because of these benefits. So, when you buy a LEAP, it is very important to set a mental stop-loss on the underlying stock so that you're not left holding a losing position for a long time to come.
If you're an option buyer and the stock closes below this stop loss, you should sell the LEAP. This will usually protect you from losing much or your entire option premium if the stock declines. An option buyer's major sin is to let time premium, and therefore profits, slip away.
This stop loss you use should be a "trailing stop," one that's just below the market value that will help you to preserve any profits that you gain along the way. As the option increases in price due to a rise in the stock, you keep moving up the stop-loss level so that it is never more than 5% or 10% below the stock price.
But if the stock price declines, you do not adjust the trailing stop. This way, if the stock declines from its high you will be able to sell the LEAP in plenty of time to preserve most of your profit.
TAKE A LONGER-TERM VIEW OF SHORT-TERM MOVES
Options value tends to dissipate quickly in the last six months before expiration, with the time decay being most-rapid as their last trading day approaches. So if you own a LEAP that is out-of-the-money when it moves into its final six months of life, you should strongly consider closing your position.
Another key to buying LEAPS and in-the-money options is to make sure that you are paying a fair price. These options cost more than short-term, out-of-the-money options, so your risk in the event of a price collapse is greater. The less money you have on the table, the less your risk will be.
One of the beautiful things about buying LEAPS is that many tend to be undervalued because option traders mainly focus on trading short-term options and simply extrapolate short-term trends out into the future to find a price for a LEAP.
If it's a stock that you would consider owning for the long term, regardless of any short-term moves that might be caused by the shares trading with the broader market trends, then you may want to test-drive the stock by owning the LEAP first and then using the option to buy shares at the strike price whenever you're ready.
