Three Questions from a Reader

1. What’s your strategy on buying LEAPs options? In order to avoid time decay, when do you roll out if you have a long term view and would like to hold on the securities as long term investment? I guest the pros probably do it within at least 6 months of remaining time value?

    I do not buy LEAPS or any other options.

    If I were to buy LEAPS calls, I would buy options that are in the money — but ONLY on a stock that I want to own because I anticipate that the stock price will move higher.

    When buying any option, “worrying” about time decay is important – but it is not your primary consideration. And when buying LEAPS options IMPLIED VOLATILITY (IV) is far more important than time decay. I know that you are new to options, but please take this statement as true: When you pay too much for the options, your chances of making money on the trade are reduced significantly. It is a very bad idea to buy LEAPS options when IV is relatively high. To get more information on IV, read this article and follow the links.

    When you have a long-term view and when you know that you plan to own the options for a long time, then you want to buy an options with less time value (rather than one with more time value). That means owning an option that is even deeper in the money. In this example, I would buy the Jan 2016 70 call with no plan to roll until expiration is nigh (unless I roll to a higher strike price, per the discussion below).

    I would roll ONLY when two conditions are met:
    I still want to own call options on this stock (as you probably do). But sometimes, you must be willing to accept the fact that this stock is not going to move higher and that you made a mistake buying the call options in the first place. Do not make the mistake of rolling just to get more time.
    Also: IV cannot be too high or else you are paying far too much for your new call option.

    When would I roll? When I have a nice profit to protect. For example, let’s assume that you buy a call option on stock XYZ whose current price is $80 per share. The LEAPS call expires in Jan 2016. I would buy the call with a strike price of $75 (In the money). If the stock rallies (assume it goes to $92) and if I believe that the stock will move still higher, I would sell my Jan 2016 75 call and buy the Jan 2017 85 call or the Jan 2016 85 call. The decision would be based on how much time remains before Jan 2016 arrives and whether I prefer to own a 2016 or 2017 call. NOTE: The Jan 90 call is not sufficiently in the money and is not a good choice for the person who plans to hold onto the option for a long time.

2. When you sell put/call options, do you sell for a 1-month expiry options or longer so that the premium is higher but takes longer for the option value to decay due to longer time frame?

I do both, depending on the situation. My recommendation for you – as a newer trader – is to write options that expire in about 60 days. That is a good compromise between less risk (shorter-term options come with little protection against a loss) and the less rapid time decay.

3. As my portfolio is small and $10k, like most rookie traders, I am comfortable with selling 1 or at most 2 covered contracts of puts/calls options. But the premiums is very little for a forward 1 month expiry options. This prompted lots of newbies, to take unusual large risky position on selling naked puts like 10 contracts which can be disastrous when volatility increased. What’s your take on this?

***If the premium is too small and if it does not allow you to make a satisfactory profit (THINK IN TERMS OF PERCENTAGE PROFIT, NOT ON TOTAL DOLLARS PROFIT) then you have chosen an inappropriate call/put option to sell. Find another stock or better yet, choose a longer term option. DO NOT increase position size just for the chance to earn more money. This is a risk that no trader can afford to take.

You may even have to find a broker who charges lower commissions, but please, never increase risk just because the potentials gains are too small. The only time to increase risk (and that would be going from 2 options to 3; never from 2 to 10) is when you deem the trade to be extremely attractive.

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