Options Interest Group LEAPS A presentation to the Denver Trading Group - Options Interest Group October 9, 2003

LEAP Basics Long-term Equity Anticipating Securities Types Underlying Expiration date Strike price Other basic factors Margin Renaming

Intrinsic Value & Time Value Stock Price = $ 56.00 50-strike Call Option = $ 9.00 Expiration = 90 days Time Value = 3.00 Stock Price = 56 Option Premium = 9.00 Intrinsic Value = 6.00 Strike Price = 50

Option Pricing Stock Price = $ 56.00 50-strike Call Option (IV = 35) = $ 9.00 Expiration = 90 days TV=9 TV=7 TV=5 TV=3 Stock Price = 56 IV=6 IV=6 IV=6 IV=6 Strike Price = 50 Imp V = 35 Imp V = 50 Imp V = 65 Imp V = 80

Option Pricing Stock Price = $ 56.00 50-strike Call Option (Exp = 90) = $ 9.00 Implied Volatility = 35 TV=5 TV=3 TV=2 Stock Price = 56 TV=1 IV=6 IV=6 IV=6 IV=6 Strike Price = 50 Exp=30days Exp=60days Exp=90days Exp=180days

Call pricing curve

Call pricing curve (cont.) Time value premium is greatest ATM Intrinsic value is zero until strike price is passed.

Call pricing curve (cont.) As IV shrinks, the price curve merges with the intrinsic line. As expiration draws closer, the price curve merges with the intrinsic line.

Call pricing curve Time value is highest ATM Far ITM and OTM time value = 0 OTM options will expire worthless if the stock moves too little Delta moves from 0 OTM to +1 ITM

Time Decay Exp=120days Exp=90days Exp=60days Exp=30days

LEAPS pricing curve

LEAPS pricing curve

LEAPS pricing curve (cont.) LEAPS ITM delta is lower Difference in LEAPS prices increases as the LEAPS becomes ITM LEAPS curve is quite flat LEAPS OTM delta is higher LEAPS have little time decay

LEAPS & interest rates r = 9% r = 6% r = 3%

LEAPS & dividends $1 dividend increase With current dividend

Comparing LEAPS and short-term calls Change in price of the options 20% OTM ATM 20% ITM Variable 3-mo 2-yr Stock (+1 pt) .03 .41 .54 .70 .97 .89 Volatility (+1%) .43 .21 .48 .04 .33 Int. Rate (+1/2%) .01 .27 .08 .55 .14 .72 Dividend (+$.25/qtr) -.62 -.08 -1.18 -.14 -1.50

Comparing LEAPS and short-term calls Change in price of the options 20% OTM ATM 20% ITM Variable 3-mo 2-yr Stock (+1 pt) .03 .41 .54 .70 .97 .89 Volatility (+1%) .43 .21 .48 .04 .33 Int. Rate (+1/2%) .01 .27 .08 .55 .14 .72 Dividend (+$.25/qtr) -.62 -.08 -1.18 -.14 -1.50 Delta!

Comparing LEAPS and short-term calls Change in price of the options 20% OTM ATM 20% ITM Variable 3-mo 2-yr Stock (+1 pt) .03 .41 .54 .70 .97 .89 Volatility (+1%) .43 .21 .48 .04 .33 Int. Rate (+1/2%) .01 .27 .08 .55 .14 .72 Dividend (+$.25/qtr) -.62 -.08 -1.18 -.14 -1.50 Delta!

Comparing LEAPS and short-term calls Change in price of the options 20% OTM ATM 20% ITM Variable 3-mo 2-yr Stock (+1 pt) .03 .41 .54 .70 .97 .89 Volatility (+1%) .43 .21 .48 .04 .33 Int. Rate (+1/2%) .01 .27 .08 .55 .14 .72 Dividend (+$.25/qtr) -.62 -.08 -1.18 -.14 -1.50 Delta!

Comparing LEAPS and short-term calls Change in price of the options 20% OTM ATM 20% ITM Variable 3-mo 2-yr Stock (+1 pt) .03 .41 .54 .70 .97 .89 Volatility (+1%) .43 .21 .48 .04 .33 Int. Rate (+1/2%) .01 .27 .08 .55 .14 .72 Dividend (+$.25/qtr) -.62 -.08 -1.18 -.14 -1.50 Delta!

LEAPS Strategies For stock currently held long LEAPS instead of short stock Protecting existing holdings with LEAPS puts As a stock substitute Speculative option buying Selling LEAPS LEAPS spreads

Long Call +5 45 50 55 60 -5

JPM Stock vs. Purchase Date = 12.31.02 Purchase Price = $24.00 Last Date = 10.06.03 Last Price = $35.55 ROI = 48%

JPM 20 Call Jan’04 LEAPS Purchase Date = 12.31.02 Purchase Price = $6.20 Last Date = 10.06.03 Last Price = $15.60 ROI = 152%

Vertical spreads Directionality is the primary concern Initially bullish or bearish Remain bullish or bearish regardless of changes in market conditions Volatility is a secondary concern At expiration A minimum value of zero (both options OTM) A maximum value of the spread (both ITM)

Bull Call Spread Sell a call at a higher exercise price Whenever the trader buys the lower exercise price and sells the higher exercise price, the position is bullish! Buy a call at a lower exercise price

LEAPS Vertical spreads Plenty of time for stock to move OTM LEAPS options are inexpensive You can make money before the expiration BreakEven Recent volatility (rare) Stock has fallen significantly in the last year or two

Extremely aggressive (OTM) Stock Inexpensive Remote chance

LEAPS BuCS EBAY

LEAPS BuCS CTRX

LEAPS BuCS CTRX (cont.)

Bull Put Spread Sell a put at a higher exercise price Whenever the trader buys the lower exercise price and sells the higher exercise price, the position is bullish! Buy a put at a lower exercise price

Extremely aggressive (OTM) Stock Inexpensive Remote chance

LEAPS BuPS MSFT

LEAPS & Butterfly’s Delta neutral Cheap when using OTM Butterfly’s You can trade the body’s Your position gets higher gamma when you buy back the body’s

LEAPS OTM Fly INTC

LEAPS OTM Fly INTC (cont.)

LEAPS & Calendar Spreads Delta neutral Increased risk due to larger debit May need to buy fewer calls than you are selling due to the higher delta of LEAPS

LEAPS Cal Sp PSFT

Acknowlegements LEAPS Comparison chart Risk Graphs Options as a Strategic Investment, Larry McMillan Risk Graphs Optionetics Platinum, www.optionetics.com