Using Options to Buy Stocks: Build Wealth with Little Risk and No Capital [Paperback]

Leap Year Poaching profits with LEAP puts

By Michael Santoli

Yes, it's been a treacherous market the past week -- all year in fact -- full of choke lines and obscured quicksand pools to menace anyone who's strayed off the narrow path that leads to the few favored stocks. Yet even in such a trying environment, money is left unattended for the poaching in some corners of the market. In one, the sales pitch is this: "I'll pay you cash today and you can keep the money if, among a selection of high-quality stocks, no more than a few have fallen by 30% or more in a year or two."

In brief, that's the offer that certain disciplined sellers of long-term puts take up with relish. Dennis Eisen, a mathematician and consultant who has devised a system for selling LEAP puts with impressive success, is one such investor. LEAPs (short for Long-Term Equity Anticipation Securities) are options that expire in January of each year and mature two or three years from the time of their listing. By selling LEAP puts, one is taking in a cash premium in hopes that the underlying stock won't fall below their strike price by expiration, in which case it's necessary to buy the stock at that level.

Eisen crafted his methods after running a huge simulation of the results of having continually sold puts on each of the 300 or so available LEAP stocks over the past decade. Encouraged by his data, he's been doing so for his own account for years with fine results and has written a new book, Using Options to Buy Stocks, that describes his approach.

Put selling has a partially justified reputation as a high-risk game, exposing the seller to unquantifiable losses should a stock plummet and force the seller to buy it at above-market rates. But by focusing on long-dated puts, restricting the activity to high-grade stocks and following certain risk-limiting rules, Eisen has found that his program acts as a nice profit enhancement to his straight stock portfolio. He says that only five times in over 1,000 trades in recent years has he had a stock "put" to him, a testament to the steady bull market and his discipline.

To locate the most solid companies, Eisen restricts his put sales to stocks with consensus "buy" ratings from research houses Zacks or S&P. One rule he advocates is to select a strike price equal to about two-thirds of a stock's current value, leaving a good deal of room for the shares to fall before the seller goes into the red.

There are logistical issues that put sellers must deal with. A broker has to be found who is comfortable with put-selling programs, margin requirements must be attended to closely and the investors should know all tax angles -- all concerns Eisen deals with carefully in his book.

He also is not promising unrealistically gaudy profits from his strategy. Eisen says he has a rather conservative, blue-chip stock portfolio and prefers to play the flashy technology stocks by selling puts against them as a source of funds to plow back into his core stocks. As a rule of thumb, he says his brand of LEAP put-selling can augment an expected 15% base return from his stocks by an additional 10% or so.

This book is a singular, well conceived investment strategy lesson in several respects. It's rare that such a book can captivate an audience of beginning, intermediate and advanced investors, but I suspect investors of just about any caliber will find this worthwhile reading. That is to say, most readers will likely find something new here about calls and puts (both the regular option and LEAP flavors), although the author does well to stick more or less exclusively to LEAPS put writing. Also, the author uses historical runs to substantiate the tactics he's advising, which make his claims all the more informed and interesting.

Eisen addresses the key issues of rate of return, risk, and probability exceedingly well, and he contributes something altogether new to the field --probability tables, based on an issue's earnings growth and volatility. The author also addresses the proper allocation of margin, option taxation, and gives a decent explanation of option volatility. The book's essential and recurrent theme is that LEAPS puts tend to completely disregard an underlying issue's earnings growth potential.

The book's essential shortcoming is that its underlying option pricing formula, which accounts for stock dividends and American style options unlike the European-styled Black-Scholes model, is delineated for copy in the text as a BASIC program rather than as an EXCEL spreadsheet. Unless the reader is using BASIC, which seems unlikely to me, he or she will find the awaiting transcription task a substantial chore. And the volatility calculation Eisen suggests is based on a year's worth of an underlying issue's price data. The book might have included a macro spreadsheet for all of the requisite data and calculations, or the author might have made such a spreadsheet available for extra cost, which I --and I am sure many others-- would gladly pay.

The author starts off by telling us how he had been able to amass a decent-sized portfolio over the years. He had a couple of hundred thousand dollars saved away, all invested in good long-term stock investments. He wished there was a way he could generate more income on-top of his already solid investments.

He started out by selling covered calls on some of his stock portfolio. That worked for a while, but he soon became frustrated that some of his best performing stocks were being called away, while he was left with a portfolio of poorly performing stocks. That is one of the down sides to covered call investing.

So he tried selling put options instead. Selling a put option is when you promise to purchase a stock at a specific price. In exchange for this promise you get paid a premium up front.

The author has found a lot of success picking solid companies, with sales and earnings growth, and selling put options one or two years out (LEAPs). Most of the LEAP puts he sells expires worthless, thus allowing him to keep the premium as profit, and sell some more long-term puts for more premium.

Most of the book deals with his back-testing data for this theory. He tests different quality stocks, different expiry dates, and different strikes. All in an effort to find the best overall results. In the end, some of his data suggests that selling long term puts at a strike price below the current price on the highest quality stocks has a 95% plus success rate.

If this type of theory interests you, I suggest getting this book and studying the theory and data for yourself.