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Friday, 05/20/2011 9:31:19 PM

Friday, May 20, 2011 9:31:19 PM

Post# of 259
~The Mathematical Dynamics of Covered LEAP's~
Let me go through the math of an entire position set-up so it can give you guys more clarity...Let's use my Ford position since we've been referencing that one anyway...

When structuring these positions, you always want to have two key numbers in mind...

1) Your called return = (the return that you get if your position is called out)

2) Your unCalled Return = (the return that you get if your position is not called out)

...Before establishing any Covered LEAP position, you need to know exactly what these two returns are so you can weigh the risk/reward...

So lets go through the math...

1) <Long side> = BUY ~F~ Jan 12.50 call @ $3.20

2) <Short Side> = SELL ~F~ June 15 call @ $0.57

In effect, we pay 3.20 and get a debit of 0.57

"Called Return"

Figuring out the "Called Return"...To get called out, that means that ~F~ trades above $15 a share by the end of the June expiration...This is what happens...

1) We owe the buyer of our June 15 call one-hundred shares of ~F~ at a price of $15...

2) We are owed one-hundred shares of ~F~ at a price of $12.50 from the seller of our ~F~ 12.5 call...

3) Your broker will automatically handle this transaction...(It is called exercising an option or being "Called Out"...

4) So we buy 100 shares of ~F~ for $12.50 and instantly sell those shares for $15.00...Leaving us a profit of $2.50...We add that to the Debit we received for selling the 15 call, which was 0.57...So 0.57 plus 2.50 = $3.07...but, remember, we paid $3.20 to establish the position...

5) So with this covered LEAP position established the way that it is, our "Called Out Return" equals negative .13 cents...(3.2 minus 3.07)...which is also a loss of 4.06%...


6) In summation, we paid out $3.20 and were returned $3.07 which is a 4.06% loss...So if ~F~ trades above $15 by the end of June exp. we can expect a max loss of 4.06%...



"Un-Called Return"

Figuring out the "Un-Called Return"...For the position not to get called out, ~F~ needs to trade below $15 a share by the end of the June expiration...This is the mathematics involved...

1)We paid out 3.20 and recieved 0.57...

2)3.20 divided by 0.57 = 5.614

3)100 divided by 5.614 = 17.81

4) So $0.57 cents is equal to 17.81% of $3.20...

5) In summary, if ~F~ is below $15 by June options exp. then we keep a profit of 17.81%...Our "Un-Called Return" is +17.81%...Since we did not get called out, we have the choice to sell another front month and bring in more money...




Putting these numbers in perspective...
So the way that we structured this position gives us the following risk/Reward ratio...

...Risk/Reward Ratio
= -4.06%/+17.81%



Obviously, I thought that this particular Risk to Reward ratio was worth it because I established the position...

Understandably, some traders prefer different/better risk/reward ratios...Most of the time, you dont want to target a Risk/Reward that has a negative return...I only accepted this negative risk position because the un-called return is over 17%...{By the way, 17% a month isnt bad}...

Had I been a little more conservative, I could have achieved a position that had both a positive Called & Un-called return...Usually, if both returns are positive, then the trade off is less premium...For instance, I could have got a "Called Return" of +3-5%, but the trade off is that my un-called" return would have been 8% - 10%...(That is still a good profit for a months worth of time)... ...In this case, I just chose to accept a bit of risk for the exchange of a very nice premium...(17.81%)...Typically, you want to stick with both scenarios giving a positive return...

It's very important to do the math before you ever make the trade..."Plan the Trade...And Trade the Plan"...

I rarely hold the short side of the trade the entire time...It's best (in my opinion) to close the short side early (especially at a support level)...There are many things that you can do to manage positions depending on the situation...For instance, if ~F~ was trading at $15.09 on the last day of exp. , I may just buy back the position and re-establish another one further out in time...I usually do that if I really would like to keep the long side of the trade, and did not want to get called out...

Theres a lot of information to digest here, so last words of advice...Practice, Practice, Practice...You will master Covered LEAP's and even develop your own strategies...

~6979~










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