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

The Dow rose 155 points on Friday. And today, stocks are rising in Asia. Oil is over $74. Gold rose $13 on Friday… to close at $954. And the dollar is killing us softly… sinking to $1.43 per euro on Friday.

Stocks and oil are at their highest levels so far this year. With such profits at hand people figure they don’t need the dollar. Investors run to the safety of the greenback when financial storms approach. But now… they think it will be clear sailing.

“Worlds bankers suggest rebound may be under way,” says a headline at the New York Times.

Is the world economy really recovering? Should you buy stocks now to take advantage of this new bull market?

You already know the answer, don’t you, dear reader.

After a fall comes a bounce. And along with the bounce come a lot of silly ideas. You see how it works? “Markets make opinions,” say the old timers on Wall Street. When stocks are going up investors find reasons why they are going up. Pretty soon, they’ve convinced themselves that they’ll go up forever.

But bounces do not last forever. They aren’t giant turtles… they’re moths. After a few months of flitting around bright lights, they dry up. When exactly this summer of winged love will end, we don’t know. September or October is our guess. But we have little doubt it will come to an end soon.

Ultimately, stock prices depend on earnings. People compare the rate of return they can get from stocks to what they can get from other investments. Rising earnings signal higher rates of return, so investors pay more.

During the great credit expansion of 1945-2007, businesses could anticipate, generally, rising earnings. People were buying more and more things on credit. In a national economy, businesses pay wages and then the employees use the wages to buy products. The wages are a ‘cost’ to the business… but they are also the source of business revenue. When sales come from credit, on the other hand, businesses have the revenue but no wage cost. Profits go up.

Now, the cycle has turned. Businesses still have the wage cost. But instead of using the money to buy things, the employee uses it to repay loans for purchases made last year or the year before. Now the business has the cost but not the revenue.

As they say in the economic textbooks: bummer.

The process of de-leveraging will be slow. Maybe 5 years. Maybe 15. Maybe 25. It will up and down… with high unemployment (businesses will cut their wage costs as sales fail to recover)… low prices (at least in real terms)… low profits… and slow growth, or none at all.

Is that bad? No, not at all. It’s good. Economies need to adjust to the new realities of the post-credit bubble world. It will take time. And with the world’s financial authorities fighting it every step of the way… it could take a LONG time. As we’ve explained in these Daily Reckonings, government is a profoundly conservative, parasite-protecting enterprise. It cannot draw forth the future – it has no idea what the future will be. Instead, all it can do is to try to recover the past. That’s the idea of the ‘recovery’… to try to coddle, protect and pay-off yesterday’s success stories. From Wall Street to welfare… governments attempt to prevent correction.

And more thoughts:

*** The Obama administration announced that it expects $9 trillion in deficits over the next 10 years. One of the great mysteries of our time is: where will the money come from? As we pointed out last week, even if every dollar of US savings is applied to the task, the feds will still be short. And if they make up the difference with funny money – from their quantitative easing scam – the Chinese vigilantes are likely to get cheesed off and dump their US Treasury bonds.

The evidence shows that the Chinese…and other Asians…are already trying to lighten up on their US debt holdings. This from the New York Times:

“Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month’s data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

“Nonetheless, the decline highlighted a fact… Asia’s appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits… In the first half of 2009, China and Hong Kong acquired only 9 percent of the more than $800 billion worth of Treasuries that were sold.

“ Japan, which was replaced by China as the largest foreign holder of Treasuries last year, has been a larger buyer this year, taking up 11 percent of the new supply of Treasuries.

“Ownership of US Treasuries by China, Hong Kong, Japan, South Korea, Singapore, Taiwan and Thailand — since 1994 — rose to 25 percent, from less than 8 percent. Since then, as budget deficits in the United States grew, the share has fluctuated within a narrow range. In June, it was 24.7 percent.”

If Asians don’t finance US debts, who will? We don’t know… But the fewer bonds Asians buy… the more they are bought with funny money by the Fed. And the more the Fed buys with funny money the fewer Asians want to buy with real money.

How will this end? Badly…we keep saying. There is no way out. Either the feds cease spending more than they can raise honestly, by taxation and reasonable borrowing. Or, the system runs into chronic, mega deficits…like the chronic deficits in the private sector during the bubble years. Then, it blows up.

That is why we caution readers against the dollar and against Treasuries. Most likely, they will both go up this autumn…as investors flee to safety from the next market downturn. But the chances of them blowing up completely are too great. That’s why we stick with gold – even though we would not at all be surprised by a period of weakness in the gold market.

*** On Friday night, we went to a ‘dinner in white’ at a nearby chateau. It was a jolly affair, at an ancient chateau entirely surrounded by a moat.

We set up our table, alongside the others. We gathered for drinks. We saw old friends. And then we prepared for dinner.

Why “white?” The dinner marks the occasion of the Assumption of the Virgin. It’s held each year in this rural area of France. Everyone brings a full dinner service – table, chairs, candles, etc. etc. Then, after setting up outside, under the stars… there’s a twist. Couples switch around so that your editor ends up having dinner with a woman to whom he is not married.

Having dinner with someone else’s wife can be a delight. At least, you have nothing to argue about. But how much of a delight it is depends entirely – or perhaps mostly – on chance.

In our case, we were trebly lucky. In front of us was a charming woman who turned out to be a relative of many people we already knew. So we kept up a lively conversation about cousins, uncles, aunts… family tragedies… and upcoming marriages. On our right, was a cute woman with a bright smile and a friendly manner. On our left, was another charming woman with a shrewd, fast wit.

Time passed quickly. We crossed swords with the woman on our left – over education policies. We chatted with the woman in front of us – about family, the weather, local trends, food and whatever. We flirted with the woman on our right:

“Do you come to these dinners often,” we asked.

“About as often as you do,” came the reply, “once a year.”

“Well, the dinners suit you. You look very nice in white.”

“Thanks… but I really don’t have any choice. It’s a ‘dinner in white,’ after all. If I had a choice, I’d wear black.”

“Why… because you have a black, cruel heart? Or is it because you are in a sad mood? I hope not. And if so, perhaps I can cheer you up by telling you joke. How many Belgians does it take to change a lightbulb?”

“I’ve heard that one.”

“Then why does the guy from Belgium go to sleep with one full glass of water next to his bed and one empty glass?”

“I don’t know… why?”

“Because he never knows if he’ll be thirsty or not when he wakes up in the night.”

“Oh…”

Source: The Future Will Come