This section describes how to use rolled LEAP call options as a cheap, long-term, leveraged investment. This technique is used in the Index Roll leveraged investing strategy. While the mechanics are simple, the explanation and background is necessarily lengthy to help answer the inevitable questions about how it works, what the limitations are, etc.

This section will assume the reader understands what a call option is, what a strike price is, and what an expiration is. If options are completely unfamiliar, visit the Options Basics Tutorial to learn more.

Most options are used by traders to benefit from short-term movements in the market. Traders who believe that a company's stock price will jump in the next few months will then purchase options instead of shares of stock in order to increase their leverage and get a higher percentage return.

However, since 1990, the Chicago Board of Options Exchange has been selling LEAPs on selected stocks and indexes. LEAP, which stands for Long-term Equity APpreciation, is an option that expires in 18 months or more.

The availability of LEAPS allows investors to benefit from long-term movements in the market. Access to LEAPS is expanding, and investors can now buy LEAPS on more and more securities for longer and longer terms. For example a LEAP can be purchased today on SPY, the S&P 500 Index ETF, that won't expire until December 2009, almost three years.

Because LEAPS allow an investor to purchase a share of stock by making two separate payments over a long period of time, they are actually a financing instrument. An option and an exercise can be viewed as an installment sale.

Purchasing a LEAP will always be more expensive than purchasing the underlying stock because of the time value involved. However, the difference can be extremely small, resulting in the seller making a very low interest loan to the buyer to acquire the stock. It is often possible to buy a LEAP in which the expected appreciation of the security is well above the implied financing cost.

Let's look at two LEAPS, both call options on SPY, both expiring in almost two years, but with different strike prices. SPY is the S&P 500 index fund and is currently trading just below $145.

The first option has a lower strike price, and is initially more expensive. However the sum of the two payments of the first option is cheaper: 41.40+110.00 = 151.40, vs 25.50+130.00=155.50.

An investor who is interested in owning SPY in two years as cheaply as possible would be better served by buying option A vs option B.

Buying and later exercising option A is still $6.40 more expensive than just buying shares in SPY. However, the buyer gets to hold on to their $110 for a full two years before they buy. They could put it into other investments or keep it in a savings account.

Buying now and paying later makes this a loan, and a loan at an exceptionally good interest rate. $6.40/$110 is 5.8%, and that's for two years. The APR is only $2.9%. However the expected appreciation of the S&P 500 Index is about 10%.

Why would the seller loan money to the buyer so cheaply? Because they want the $41.40 today, which they will re-invest for the two years until the option expires. This up-front payment will also help compensate them for the stock's downside risk.

1. Because a LEAP involves two payments, one now and one later, a loan is involved. Depending upon the strike price of the option, the loan can be on extremely favorable terms.

2. LEAPs with lower strike prices have higher up-front costs but lower total costs over the life of the option. This is because the seller receives more cash up front and is better compensated for their future risks.

Wait... But Aren't Options Incredibly Risky?

Now is the best time to mention that there are a lot of negative opinions associated with options. They're bad bets, 90% of them expire unexercised, buying an option is betting against the casino, they're high risk investments, they're too expensive, etc, etc.

Most of these sterotypes are extremely out of date, and are based upon experiences with short term, at-the-money or out-of-the-money options. If you haven't looked at LEAPs, or specifically LEAPS on indexes at low strike prices, please check out the purchase prices for yourself rather than assuming the worst.

The Roll is a financial transaction that consists of rolling a long-term call option (or LEAP) forward to get an additional year's worth of appreciation from the underlying stock.

Depending upon the stock and the circumstances, this can often be done extremely inexpensively. This is the technique at the heart of the Index Roll strategy.

Rolling an option forward can be done again and again, year after year, for as long as options are still traded on the underlying security.

This technique only works for LEAPs, i.e. options that have at least 18 months before expiration. For best results, these LEAPs should be well in the money.

Also, the technique is most useful for stocks with low volatility, including indices and large caps. These securities can be rolled very cheaply.

As the option is held and rolled forward for years, the value continues to appreciate, based upon its intrinsic and time value. The investor can then sell it at any time.

Example

We'll model a Roll Forward transaction by looking at the price difference between two call options on the SPY. They have the same strike price but different expiration dates.

(SPY is trading at about 145.)

If an investor wanted to sell option A and buy option B, it would cost him or her $3.40. ($41.40-$38.00).

$3.40 buys an additional year's worth of appreciation on an asset worth $145 that's expected to grow at 10% a year. That's a pretty good deal.

We could also say that the investor is paying $3.40 for an expected $14.50, a +326% annual gain.

Or another way to look at it is that the investor is borrowing $110 for a year for $3.40. That's 2.9% interest.

The investor would then hold option B for another year and then sell it and replace it with another option with a later expiry.

By selecting higher or lower strike prices, we can take on more or less leverage in our portfolio. In our experience, buying options with a strike price of 10-20% below market seems to provide the best combination of safety, low roll forward costs, and lowest initial prices.

Although its impossible to exactly predict future roll forward costs, let's look at some options on SPY to see what kind of leverage is available and at what cost.

We'll also calculate a 2-yr return and a 3-yr return for the option based upon 10% annual growth in the underlying asset. To get the 3-yr return would require paying the initial option cost and then rolling the option forward next year.

SPY is trading for a little over 145 today.

Roll Fwd: The difference between the two prices. This is also the expected roll forward cost for next year.?* % Roll Fwd of market price: Roll forward cost as a percentage of the price of the underlying. This could be considered the interest rate on the portfolio.?* 2yr expected return: % return on this option, if SPY returns the expected 10% a year.?* 3yr expected return: % return on this option, if SPY returns the expected 10% a year.

Some interesting conclusions can be drawn from this table.

1. All of these options are great investments if SPY returns the expected average 10% over the period. 2-yr returns of 50% to 89% are nothing short of amazing, and the 3-yr returns are great too. That's the power of leverage.

2. The option with the highest strike price (140) has the lowest initial cost and the best expected returns. However, it also has the highest roll forward cost, which means that if SPY doesn't perform as well as expected, its easy for borrowing costs to outstrip appreciation.

3. The option with the lowest strike price (100) is initially expensive, at $50 a share. However, the roll forward costs are extremely low. Even anemic performance from SPY over the two or three year period will generate decent returns.

4. As our strike price gets lower, the price of the option gets higher. But this is interesting - to get a strike price 40 points lower only costs $31.60 more per share. It looks like we can buy $40 of potential equity in two years for $31.60, a 26.5% return.

5. As our strike price gets closer to market, roll forward costs go up. This gives us an indication of what will happen if the price of SPY drops 10 or 20 points next year - the roll forward cost will increase by $1 or $2 per share.

So which option is the best value? Well, they're all good values if we believe that SPY has good long-term appreciation potential. There's nothing wrong with choosing an option with a higher strike price, assuming that the investor has extra cash on hand for paying the expected higher roll forward costs in the future. The higher strike prices will give better returns overall, although short-term volatility will also be higher.

On the other hand, low strike prices will help an investor sleep better at night. The up-front costs will be high, but he or she will know that the roll forward costs are manageable and that even in a sideways market they'll do all right.

The 120 or 130 strike price looks like a sweet spot. Relatively low roll forward costs and low initial costs, combined with high expected returns. From our experience, options with strike prices 10-20% below market or so seem to provide the best results.

More than 25%+ is overkill. At that point, the investor would most likely be better off putting the extra money in a savings account and using it to pay roll forward costs as needed.

While the investor rolls the option forward, they can also roll it upwards to a higher strike price. The new option will be cheaper, which means that the investor will receive cash back in the transaction.

This is generally done to pull cash out of an appreciated investment. However, because of delta, the investor will always lose some cash in this transaction. The closer the new strike price is to the market price, the more cash they will lose. (Due to delta, explained below.)

For example, today SPY is trading at 145, and an investor who rolls over SPY from a 110 strike price to a 120 will receive $9.10, rather than $10. (Use the difference between the two bid prices to calculate this.)

Rolling up should be done infrequently, only when the option is deep in the money, and at the same time as the roll-forward. However it doesn't change the underlying portfolio, just the amount of leverage.

Sometimes a roll up is forced, for example when the underlying security appreciates so much that lower strike prices are no longer available going forward. This is a good problem to have, obviously, and the investor can just select the lowest available strike price and keep the remainder of the cash for other investments.

Rolling Up occasionally is a good way to generate cash for future investments, but investors need to be careful to invest the cash over time rather than re-investing it immediately and potentially buying at the top.

The easiest way to estimate a Roll Forward cost is by looking at the price difference between the ask price of a two-year option and the bid price of a one year option. This is a good indicator of what the Roll Forward costs will be in every year for the next few years.

However, Roll Forward costs for a LEAP will vary over time based upon a number of factors, including appreciation and volatility in the underlying security and interest rates. (Supply and demand is not really a factor as options are priced by computer to eliminate arbitrage.)

The most important factor is the price appreciation in the underlying security. In general, for every $1 of price appreciation in the underlying security, the roll forward cost will decline by $0.09 to $0.06, depending upon the distance from the strike price.

This means that as the security appreciates, the roll forward cost will decline. The cost of holding the leveraged asset actually decreases.

Other factors such as volatility and interest rates do influence the price, but appreciation is by far the most important factor for an option with a strike price that's at or below the market price.

Many option pros "psych themselves out" by worring about vega or rho or some other greek when they should really be focusing on the appreciation of the underlying security.

There's a lot of confusion about options and dividends. The party line is "option holders don't get dividends", which is technically true. But that doesn't necessarily mean that options on dividend paying stocks are a bad deal.

Future dividend payments are one of the factors that is baked into the price of the option, which means that stocks that pay hefty dividends have much cheaper LEAPs.

Look at a LEAP for a high-dividend stock like Bank of America and you'll see what we mean. The LEAP barely costs anything, thanks to the dividend. The option writer is passing on the benefits of the dividends to the seller.

Indexes don't pay a lot of dividends, but they do pay a little, and they do continue to raise their dividends, which does help to lower the cost of holding and rolling forward an index option.

Every option loses time value every day as it moves closer to expiry. This phenomenon is named time decay, and the rate of decay is named theta.

Theta increases as an option gets closer to expiry. Given identical strike prices, a two-year option will have a much lower theta than a one-year option.

This presents an opportunity to purchase an option with a low theta, and then after a year, when the theta increases, to replace it with a new option with a lower theta.

Long-term, deep in-the-money options on less volatile securities have the lowest theta, and a low theta allows an investor to purchase the future appreciation very cheaply.

A $1 move in the price of underlying security will not immediately translate into a $1 move in the price of the option. Options have a variable named delta that measures how sensitive option price changes are to changes in the underlying security.

Delta for option increases as the option gets closer to expiry. Delta for a two-year LEAP on an index might equal 0.8 when purchased. As an option moves closer to expiration, delta gets closer to 1.0.

In practice this means that when an investor initially purchases a long-term option, it will be less sensitive to changes in the underlying security. But if the investor continues to hold the option and roll it forward as required, virtually all of the appreciation in the underlying security will be captured by owning the option.

However, if the investor chooses to Roll Forward and then Roll Up at some pont, then it is likely that they will lose some of the value from the underlying security, depending upon the delta, which is a function of how far away from expiry the option is, how close to market price the new strike price is, and the volatility of the underlying.

Buy a LEAP with a strike price at or below market price and an expiration at least 18 months out.

Hold the LEAP for a year - until there's only 9 to 12 months left before expiration.

Sell the LEAP and replace it with a LEAP with the same strike price and a later expiry (as long as possible). Or alternately, raise the strike price to pull cash out.

Go back to step 2 for a few years to keep benefiting from the appreciation in the underlying security.

Sell the appreciated option at any time.

• The Roll is an excellent strategy for getting cheap leverage on a long-term, buy and hold investment with low volatility, such as an index or large-cap stock.

• The Roll is the cheapest way to own the index for the long-term. Instead of buying the index outright, buy a LEAP with a low strike price and put the remainder in other diversified investments.

• On many stocks and indexes, the cost to roll the security forward is only about 2-4% of the cost of the underlying security. Lower strike prices result in lower roll forward costs.

• As the investor continues to roll the options forward, the underlying security appreciates, making the option more valuable over time, and the roll forward cost decreases.

• During a market correction, the option will lose value and the roll forward cost will increase. Investors need to hold on to their options and to continue to roll them forward on schedule, or they'll end up making a temporary loss permanent.

• An option on an appreciated security can by Rolled Up to withdraw cash and increase leverage. This is best done during a roll forward transaction. However, some appreciation will be lost, due to delta differences.

• An investor can sell the option at any time to immediately receive the intrinsic value and the remainder of the time value.

Here is a roll forward simulator. Calculates the roll forward cost based upon fifty potential outcomes. Also has some index roll return calculators.

http://www.indexroll.com/roll-forward-sim.xls

An analysis of rates of return for different one-year options on SPY. Created using an option calculator, and based upon relatively placed market conditions and low volatility. This confirms that the biggest gain comes from out of the money options. A one-year, +25% out of the money option has an average return of 75.39%. This is partly because current volatility is lower than the 15% average used in making the model, but if you can think of other reasons, let me know.

http://www.indexroll.com/one-year-option.xls

1) I know a great stock. Why shouldn't I choose that over the index?

2) What happens when I can't roll forward my LEAP?

3) Don't you lose a lot of money on the bid-ask spread?

4) If you sell before expiry, don't you miss out on some of the appreciation?

5) We just had a correction and the market seems very volatile right now and option prices are very high. Are you sure I should buy or roll over an option right now?

6) The Index LEAP sounds like a much better deal than the Index ETF. Why would I ever own the ETF by itself? Or even invest in an index fund?