LEAPS Defensive Techniques

According to Hooper and Zalewski, in their book Covered Calls and LEAPS A Wealth Option, there are five defensive techniques to manage a LEAPS that has not sold for a profit.

1. SLR
2. Average down
3. Reposition
4. Close on delta
5. Roll out

The SLR or Surrogate LEAPS Replacement is used when 3 conditions exist:

1. An investor has sold a secondary call and the stock price has moved up, not allowing that call to be bought back for a profit.
2. The investor can sell the LEAPS for a 5 percent or better profit but is prevented from closing the transaction as doing so would result in an overall negative return due to the buyback cost of the call.
3. The stock is in the upper 75% of its current cycle.

Here's how to implement the SSR:

If the stock price is in the upper 75% of the cycle and you are able to sell the original LEAPS for a return of 5% or more, the SLR can be considered.

Select the same expiration date, move the strike price up one or two increments (preferably not equal to the strike price of the call) Buy this LEAPS and then immediately sell the LEAPS you own.

Two scenarios take place after you implement this:

1. Stock price continues up and you may be able to sell the LEAPS for a 5% profit and then buy another LEAPS.
2. Stock price declines and you may be able to buy back the call when you can exit a the cost you sold it for.

LEAPS - Identifying the First Sell Point

This is when you want to sell a secondary call. The first sell point of a new cycle is always preceded by a minimum of two bottoms and one top according to Hooper and Zalewski in their book, Covered Calls and LEAPS, a Wealth Option.

In a rising cycle you will see a break through of the top of a declining cycle. You will see higher bottoms. The first sell point is preceded by a minimum of two bottoms and one top. In a declining cycle, you will see the break through of the bottom of a rising cycle and then the first sell point is preceded by a minimum of two bottoms and one top.

It is very important to pay attention to these indicators when selling secondary calls under the LEAPS technique since you are leveraged in the positions and optimization is therefore highly important.

The Formalized Seven-Day Rule

In their book Covered Calls and LEAPS a Wealth, Hooper and Zalewski detail how to invest in LEAPS in order to generate returns in the high single digits to low teens. They go into detail on how to manage your position in the event that it is not called out. One of the rules is to only sell a secondary call on the LEAP if the Formalized Seven-Day Rule is met. Here are the details of the Formalized Seven-Day Rule:

1. The rule is essentially the selling high rule that was discussed for covered calls - secondary call sales can only be made when a stock is in the upper 75% of its current price cycle. What this means is that you take the stock's price chart, draw upper and lower trendlines around its current channel and then divide the range into quarters. Again, you only sell secondary calls when the stock is in the upper 75% of its price. The intention of this rule is to allow the stock price to drop and allow for profitable buyback.
2. A rising price cycle must have a minimum of $1.50 of price between the upper and lower lines of its price cycle.

If the stock shoots up instead of dropping as anticipated, you may be able to profitably exit on the delta effect, buy back the call profitably due to time decay or use another advanced technique to manage the position such as the Surrogate LEAPS Replacement.

There is one exception to the rule ... on a declining cycle, only buy back the call when the stock reaches the bottom 25% of its price cycle.

Secondary Call Sales on LEAPS

If you were not able to sell your initial LEAP for cost plus 5% then you should follow the rules for secondary call sales as detailed by Hooper and Zalewski in their book, Covered Calls and LEAPS, a Wealth Option.

1. A secondary call can only be sold when the markets are in the green.
2. It can only be sold after implementing either the 10 cent rule or the 5% buyback rule.
3. A secondary call cannot be sold if the mkt. bid price of the LEAPS is within 10% of your GTC sale price.
4. A secondary call can only be sold with the formalized seven day rule has been satisfied.
5. A secondary call sale should generate a minimum of 10 percent uncalled return.
6. The aim is to buy back the call for a net uncalled return of 5%.
7. It is preferable to select the same call strike price as the strike price used when the position was established.
8. Preference should always be given to a shorter term call if this provides the minimum uncalled return requirement of 10 percent.
9. If a min. 10% uncalled return with the same strike cannot be maintained, drop the strike one increment toward in the money.
10. Continue to drop to generate yield up to the point that the call strike price is equal to the LEAPS strike price.
11. If the 10% cannot be generated then the LEAPS should be repositioned.

Managing Your LEAPS

Hooper and Zalewski in their book Covered Calls and LEAPS a Wealth Option, detail the management techniques necessary to maintain high returns. While covered calls are intended to deliver returns in the area of 4% a month or 48% a year, LEAPS are designed to deliver returns in the range of high single digits to the lower teens. What this means is that one can potentially reach returns of 100% a year. A 50,000 dollar a year income can be replace with a $50,000 investment. Sound to good to be true? If something sounds too good to be true, then it is worth checking out.

The LEAPS Management Rules of Hooper and Zalewski

• The 10 Cent Rule
• The Delta Low Bridge Technique
• The 5% Buyback Rules

The 10 Cent Rule and Delta Low Bridge are applicable in a situation where the stock price has increased. If the bid price of the LEAPS increases to 10 cents above your cost in the LEAPS you buy back the short call at market price. You then add the cost of the buyback to your cost in the LEAPS and add 5%. If the LEAPS sells then you will have generated a return of 5% in a short period of time.

Under the Delta Low Bridge, you close out the entire transaction when you can realize a 5% return. The Delta is working in your favor because the construction of the LEAPS calls for a position with a delta of 1.90. When the stock price increases the LEAPS will increase at a much faster clip. When you close out using the Delta Low Bridge, you back the short call for a loss and then sell the LEAP in order to generate an overall profit. Thus, you must make sure to generate a minimum 5% return when you buy back the call and sell the LEAP.

For example, let's say you purchase a LEAPS for $10 and sell a call for a premium of $.90. The stock then goes up and thus the LEAP goes up to let's say a price of $12.00. For example sake, let's say the call has gone up to a $1.20. You can now buy the call back to close for a loss of $.30 and then sell the LEAPS for a gain of $2.00. $2.00 - .$30 = $1.70. $1.70/$10.00 = 17%.

You now have your money back and are ready to enter a new position following the rules.

In the case where the stock price drops, you can utilize the 5% Rule. Buy back the call for a net uncalled profit of 5% if market prices drop. You then add 5% to the cost of the LEAPS and put in a GTC order to sell at this price. If the LEAPS sells, you will have locked in a 10% return. To calculate the initial 5% return, you simply multiply your cost in the LEAPS by 5% and then subtract this number from the premium you received on the short call. This will be your call buyback price and you can enter a GTC order to automatically buy at this price. This will ensure that the call is bought back if the stock drops and allow you to not have to micro-monitor for this event.

Hooper and Zalewski provide a LEAPS screening tool at www.compoundstockearnings.com in the covered call toolbox. This screener includes a DLB index and ranks the positions lowest to highest according to percent increase for call out and is a very useful tool for this type of investing.

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Constructing a LEAPS Position

Okay, here is how Hooper and Zalewski tell you how to construct a LEAPS position in their book Covered Calls and LEAPS a Wealth Option. I highly recommend you purchase this book if you are serious about generating cash flow into your income column and reaching financial independence.

Selecting a LEAPS

• Select a LEAPS that is one strike in the money.
• Do not select a LEAPS that is more than $10.00 in price. This will create leverage for you and let you manage the position better in the event of a market downturn.
• The LEAPS selected must have a minimum 12 months to expiration with preference given to the longest-term available.

Selecting the Call

• Sell a call as soon as you buy the LEAP. Hesitation is for the weak and the speculator.
• Select a call that results in a positive called return ... you can find this by adding the cost of the LEAPS to the LEAPS strike price. This will give you the approximate strike price of the call.
• The call expiration cannot be equal to the LEAPS expiration.
• The combine delta ratio of the LEAP and call must be 1.90 or more. This will allow you to potentially close out on the delta effect. (this is the rate of change of the option price with respect to the underlying stock. At a 1.9, the LEAPS price will increase much faster than the cost of buying back the call.

The Delta equation in this context is as follows:

Delta ratio = LEAPS delta/Call delta

In order to complete the construction, use Hooper and Zalewski's propreitary screener located at www.compoundstockearnings.com, ensure the underlying stock position is an overall or current upward or horizontal cycle and that it meets the buying low rule.

Identifying a Change in Cycle

According to Hooper and Zalewski in their book Covered Calls and LEAPS a Wealth Option, one can identify a change in cycle by identifying when the following two events occur, indicating a change from a declining cycle to a rising cycle.

1. A higher bottom or bottoms, which may occur within the declining price cycle.
2. A break through of the top line of the declining price cycle.

According to the authors, "the first buy point of a new price cycle is literally the first point in a new cycle at which the buying low rule is satisfied" and "the first buy point of a new cycle is always preceded by a minimum of tow tops and a minimum of one bottom." The second top is higher than the first.

This is merely the first spot an investor can enter the new LEAPs position. You can also enter the position after the trend has been well established but this serves as an indicator at a minimum of when the first buy point occurs.

Bad LEAPS Construction ... Bad LEAPs ... Bad ... Sit.

As pointed out by Hooper and Zalewski in their book, Covered Calls and Leaps a Wealth Option, "there are two distinct occasions when the bottom 25 percent of a current rising or horizontal cycle is, in fact, a very poor place to construct a position."

1. The Bottom of a Current Rising Cycle That Is Part of a Longer-Term Downward Cycle
2. Current Cycles That Are Close to the Yearly High

As it relates to point one, always check the long term cycle. The stock could in fact be in a prolonged downward cycle and therefore, not an optimal investment. Make sure to check the one-year price chart, draw in the trend lines, top first and then bottom for a downward trend, in order to verify the cycle. A stock typically has broken out of a downward cycle when it has substantially broken the top downward trend line and continued up for a number of months ... at least three typically.

Number two essentially means do not buy a stock that has ascended in a straight stair fashion to its yearly high. If it has gone straight up and you are now close to a 52 week high, look elsewhere.

Again, all of this is covered in a great book on option writing, Covered Calls and LEAPS, a Wealth Option.

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The Buying Low Rule for LEAPs

As presented by Hooper and Zalewski in their book, Covered Calls and LEAPs a Wealth Option, here is the detail of the Buying Low Rule for LEAPs, used in conjunction with the rules for entering a new LEAPs position. Remember, LEAPs can potentially result in returns of 100% per year, meaning a $50,000 investment can replace a $50,000 income.

1. Investment in new LEAPS positions can only be made when a stock's overall or current cycle is increasing or horizontal.

2. Investment in new LEAPS positions can only be made when a stock is in the lower 25 percent of its overall or current price cycle.

3. A stock's current price cycle must have a minimum of $1.50 of price between the upper and lower lines for a position to be eligible for investment. This third rule ensures that there is enough potential upward movement in the stock price to exit the position.

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Below is the LEAPs investing flowchart as presented by Hooper and Zalewski in their book, Covered Calls and LEAPs, A Wealth Option. While covered calls in the book are designed to deliver returns of 3 to 6% per month or approximately 50% a year, LEAPs investing is designed to deliver monthly returns in the high single digits to low teens. What this means is that an investor can expect returns of approximately 100% per year or a payback period of 1 year. An investment of $50,000 results in income of $50,000 per year. An investment of $100,000 results in income of $100,000 per year.

Does this sound too good to be true? Some things that sound too good to be true are true. In order to separate the wheat from the chaff, you have to do your homework, stick your toe in the water and find out. Nothing great ever happens until you take action. Ready, fire, aim. If it doesn't work, readjust your aim.

The Rules for Entering a New LEAPs Position

As presented by Hooper and Zalewski in their book Covered Calls and Leaps, a Wealth Option, here are the rules for entering a new Leaps position. Remember, Leap is just another word for long-term option, and while covered call writing delivers returns in the 4 - 6% a month range, Leaps can deliver returns in the upper single digits to low teens for an approximate return close to 100% a year.

The Rules for Entering a New Leaps Position

1. You can only establish new positions on down market days. A down market day is any time the Dow and NASDAQ are in the red.
2. Use the CSE screener, provided by Hooper and Zalewski at www.compoundstockearnings.com, to filter all stocks in the market for the fundamental criteria for LEAPs investments.
3. You must follow the rules for correctly constructing a LEAPs position (discussed later). These rules are imbedded in the CSE screener.
4. Ensure that the stock adheres to the buying low rule for LEAPS (discussed later).
5. Always give priority to maintaining acceptable levels of diversification between stocks and industries (invest across the 13 varying sectors) - even if a stock you are already invested in presents an excellent opportunity.
6. Buy the LEAPs first and then immediately sell the call. Do not hesitate.

Again, the previous information is presented in Hooper and Zalewski's book Covered Calls and Leaps a Wealth Option ... an invaluable resource for anyone who wants to be financially independent.

CPR Part Three

Again, the CPR as presented by Hooper and Zalewski in their book, Covered Calls and Leaps, is used when the stock price is depressed and in a new cycle, but the cycle depth is too shallow to apply the TSS technique.

Example:

1. John owns 100 shares of FMD at a cost of $32.58.
2. He buys one $25 Jan 06 call at $4.00
3. He sells 2 $30 Jan 06 calls at $1.50.

The Net Debit of a CPR

Net debit = Price of a long call - (2 x Price of the Short Call)

$4.00 - ( 2 x $1.50) = - $1.00

$1.00 is the net debit.

$1.00 is the maximum loss to the investor.

Just to recap ...

The Cardiopulmonary Resuscitation Technique is used to:

1. Dramatically expedite the closing of a new covered call position where the stock price has suffered an immediate decline after entering the transaction. The CPR provides this ability as in many cases, it allows the investor to lower the strike price of the short call in the near month, yet continue to maintain a positive called return.
2. To generate income and reduce the cost basis in a deeply depressed position. The CPR can effectively be applied where an under performing stock is now in an upward cycle but the cycle's depth is too shallow to effectively use the TSS for income.

Construction:

1. An investor holds a long position - 100 shares of stock.
2. The investor buys one near month (or two month out) call.
3. The investor sells two near month (or two month out) calls with a higher strike price than the call in number 2.