And it’s this time component that is a critical factor when it comes to valuing the price of a LEAP option and the amount of risk involved.

An option’s price is determined by a computer program – either the Options Pricing Model or the Black-Scholes Model. Black, Scholes and Merton developed the latter model in the 1970s, winning a Nobel Prize for it.

Essentially, both models take the same main factors into account…

• The amount of time until expiration.
• The price of the underlying shares.
• The volatility of the share price.
• The risk-free rate of return.

Let’s take a look at these factors, so you know how to pick the right options with the best chance of yielding handsome profits…

Put Time on Your Side With LEAP Options

Time Until Expiration: When most people think about options, they think about getting the biggest bang for their buck and profiting in the shortest amount of time.

But be careful, because it isn’t that simple. With short-term options, time is against you. If the outcome you desire isn’t achieved within a short period of time, your option expires worthless.

However, LEAP options give you plenty of time for you to be correct and profit from the trade. Time is a critical component of a LEAPS trade.

• For example, I’ve seen a LEAP option on a gold stock recommendation move from the $3 price we paid, to $0.50, then right back up to $16… all during a 12-month period.
• Contrast that with a short-term option, which would have flamed out a long time before the share price recovered.

With LEAPS, you have time to withstand a bad earnings report, a market correction, a terrorist attack, or a plethora of other shocks that would otherwise mean a world of hurt for your position.

Stock-Watching: How the Share Price Affects the Option Price

Price of the Underlying Shares: It stands to reason that the price of the underlying shares is another key factor in determining how much you pay for the LEAPS options.

Basically, the closer the strike price (the price at which you have the right to buy or sell the stock) is to the current share price, the more expensive the option will be.

• For example, if IBM (NYSE: IBM) trades for $100, a $95 call option would be considered in-the-money since the strike price is less than the current option price. In this case, the option premium will have intrinsic value. For example, if the option cost $9, $5 of that would be intrinsic value and $4 would be the amount paid for time and risk.
• If your option is out-of-the-money, you pay for time and risk. So if IBM was at $100 and you bought a $105 call option for $5, the entire $5 would be for time and risk. But while the option premium is less than an in-the-money option, the probability of winning is also lower.

How Much Will Your Option Move? This Volatility Number Will Tell You

Volatility: When we talk about volatility here, we’re referring to how the share price performs in relation to the broader market. This is known as a stock’s beta.

Simply put, a stock with a beta of 1 will move in line with the market. A number under 1 means it’s less volatile, while a number higher than 1 means it’s more prone to volatility. So if the S&P 500 moves down 1% and your stock moves down 2%, your stock has a very high beta – double that of the market.

The higher the beta, the more expensive the options are, since options have the ability to move with greater speed in either direction.

• For example, the beta on shares of tech giant Apple (Nasdaq: AAPL) will be much higher than the beta on a stodgy pharma company like Procter & Gamble (NYSE: PG).

Risk Free Rate of Return: Measuring the cost of money at the cheapest possible price and the best possible return with no risk, this final factor is usually associated with government Treasury securities, especially 10-year Treasury bonds.

Together, these four features – time to expiration, underlying share price, volatility and risk-free rate of return – represent the critical components in determining the price of LEAP options (or any options, for that matter).

Next time, we’ll explore the economics of the LEAP strategy along with how you can invest in the market with 15% of your cash while the rest of the world is foolishly using 100% of theirs.

Good investing,

Karim Rahemtulla

Source: Put Time on Your Side With This Trading Strategy

In the past, investing in the banking sector was a no-brainer. Just buy a strong bank like JP Morgan (NYSE: JPM) or US Bancorp (NYSE: USB), sit back, and collect the healthy dividends they dished out.

There used to be an incentive to buy bank stocks because you got paid to hold them. Not any more. Few banks on the Top 50 list currently pay dividends worth noting. Worse still, most are actually cutting their dividends to pennies per year or eliminating them altogether.

So, why buy a bank stock?

The Banking Sector’s Recent Carnage

Cast your eye across the banking sector carnage and the list of the dead is impressive: Washington Mutual, Wachovia and IndyMac are among the biggest.

The list of walking dead is equally remarkable: Citigroup (NYSE: C) and Bank of America (NYSE: BAC) – two banks that once graced the Top 50. Not any more.

The main reason to consider buying bank stocks is in anticipation of a significant turnaround.

Many banks will recover from current levels and having been oversold, will provide stupendous returns in the months ahead, as the bounces will be as sharp to the upside.

But there is risk.

Last month, for example, shares of Wells Fargo (NYSE: WFC) – one of the top banks on Global Finance’s list crashed by more than 50%. The company then slashed its dividend by more than 80%. Not exactly a compelling reason to dip your toes into this sector, right?

Well, not so fast. Here’s how you can play bank stocks with low risk and very high return potential…

Using LEAP Options to Buy Banking Stocks

One of the best ways to invest in a volatile sector like banking is by using a strategy that allows you to risk just 10% to 20% of the capital that you’d use to buy the shares.

That way, if the shares move lower, the amount of money you have at risk is less than you would have risked had you placed a 20% stop-loss. But if they move higher, you’re looking at substantial returns. So what is this strategy and how does it work?

LEAP options.

The beauty of these options is that they expire in one to two years, thus allowing you to participate in the upside of a stock (or the downside if you’re buying puts) without risking the capital you’d need if you bought the shares outright. It also works well for sectors that are struggling, as it gives you more time to be correct with your call as the stocks recover.

Let’s take JP Morgan as an example…

How To Buy Banking Stocks For 5 Times Less Risk

If you wanted to buy 1,000 shares of JPM today, with a target price of $40 in two years, it would set you back a hefty $18,000. The company has the earnings power to make $4 per share in 2010 if the economy normalizes and a ten times multiple is not out of the question.

• Instead of spending $18,000 to make $22,000 – a heck of a return if you can make it – you could buy the JPM $30 LEAPS for $3.50 per contract (expensive because of the volatility). So it would cost about $3,500 to control 1,000 shares.

• If JPM hits $40, you stand to make about $6,500 for each $3,500 you invested. Sure, $6,500 isn’t as much as $22,000, but it’s still a heck of a return. And throughout the process, you gain one crucial peace of mind benefit: A lot less risk.

• To have $18,000 at risk through simply buying the shares is five times more than the money at risk if you bought the LEAP options. And if you set a 20% stop-loss, you’re committed to losing $3,600 on the JPM stock trade- more dollars than you’d risk by buying the LEAP option.

In the past, this trade would have made less sense because while in it, you’d also be receiving a couple of dollars per share each year in the form of dividends. But with no dividend to speak of any more, why put so much capital at risk?

Next time, I’ll show you how to make dollar-for-dollar gains on stocks with only half the dollars at risk!

Source: Bank Stocks: Why Using LEAPS Is The Only Way To Buy Them