Customer Reviews

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

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BARRON'S, page MW 14

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.

Jim Rogers, George Soros' former partner, onced admonished against the use of put writing, a financial instrument which brought him catastrophic losses early in his extraordinary career. Of course, LEAPS puts did not exist at the time Rogers was making use of them, and one wonders what he might think, or might have done, with Dennis Eisen's book, which makes a compelling case for LEAPS put writing.

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.

I saw this book in the book store, and spent some time there reading the first few chapters. I was so interested in his ideas, that I purchased the book. It's well-written and not at all dry, unlike some other investment books.

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.

I trade equity options. I have read a lot of books about options. Basically, once you have read McMillan's book, none of the other option books have anything to add. Except this book.
This book shows some original thinking; it's not just the same old thing about bull spreads, etc. The book advocates more than just selling puts to get premium or to use as a method of buying stock at a discount. He explains how you can sell puts on solid companies and buy stock of other companies with the premium you brought in. He really got me thinking, and I have gone from his ideas to developing some of my own.
This book is well worth reading. Read it to get ideas on how to use puts for your own advantage. Learn something new.

I picked this up ... at a book clearance sale, if you have to pay more pick another title. First of all the author says he sells puts (contracts agreeing to buy a stock or index at a set price until a specific date for which you receive a premium) to buy stocks in his investment account. There is not a single example in the book of a trade he executed this way. Instead he fills about 1/4 of the book with hypothetical computer runs assuming you had sold every LEAP contract over a multi year period. That is just a silly example for the individual investor. That is akin to comparing all of the insurance coverage written by Prudential with you writing a policy on your grandma.

Second he gives you numerous pages on how to calculate Volatility and Black-Scholes, etc. What is missed is that you want to be selling Puts and Calls when Volatility is High, and most option brokers do this calculation with a computer. As for Black-Sholes, the calculation is easy to find on the web, but any "advantage" that it may provide is used by insititutions who can rapidly scan the whole market and quickly correct any price imbalances. Unless you enjoy crunching financial formulas by hand, this section is filler at best.

Finally, his stock selection and risk control methods are questionable at best. Think Enron and realize that even "independent" reviewers like Morningstar and Value Line had it well rated up until the bitter end. If you dont already have a solid stock picking methodology, you should not start buy selling options. The notion that a reader should do anything other than sell an option that is 100% covered by CASH is the same as endorsing the methods that bankrupted many very large traders, banks and hedge-funds.

If you are looking for investment ideas Getting Started in Options may be a good place to START. Throw in Peter Lynch, Justin Mamis, and Andrew Tobias for good measure.

In his book, Dennis Eisen describes exactly one way to trade options: Selling Puts, namely LEAPS (Long-term Equity Anticipation Securities). What makes this book so interesting to read is that Eisen starts with a general overview and then goes into a level of useful detail which I have not seen in any other book on options yet. He explains how options are taxed, how the margin requirement is calculated, and what actually happens when options are exercised/assigned. This knowledge you normally have to acquire in years of practice but Eisen just spreads it out in front of the reader. Despite the level of detail the book is easy to follow, and I finished it in two days.
What makes the author very likable is that he writes in the "I" form, i.e. he writes from his experience, and not with the claim to know the absolute truth.
The book is divided in three main parts: Part one covers the basics, part two takes a quantitative look at the risk and reward of an actual system, and how you can improve your odds, and part three lists formulas and computer codes. There is also a big appendix with over a hundred tables of put premiums calculated with the Black-Scholes-Formula. The book is rounded off by a bibliography and Eisen's favorite web sites (some of them are outdated).
The main reason why Eisen prefers long-term puts (and long-term meaning up to 30 months) is that they are less risky. Due to inflation and the fact that good companies increase their earnings over time thus driving their share price up, he feels that long-term options are less likely to be assigned. For this, he is willing to sacrifice quite some put premium as the following example shows: For an American Option (stock price = strike price, volatility 0.3, dividend rate 3%) the premium for a 15 months-put is $11.46 yet for the 30 months-put it is only $15.06. In other words, although the time is twice as long until expiration, the premium increases by only 31%. In proportion, the premium for a 6-months-put is even higher, at $7.71. This is because options lose most of their value in the last months before expiration.
Here I would deviate from the author's system, I would always prefer to sell two consecutive 15-months-puts for $22.92 or even five consecutive 6-months-puts for $38.53 rather than one 30-months-put for $15.06. By rolling them out and down I would try to prevent being assigned too many stocks.
Are there any downsides to this book? Not really. One thing I did not understand is how Eisen can put the premium which he earns into a cash market account at 6% interest rate. (This contributes an important part to the profitability of his system). In chapter 4 he explains how much margin is required: The whole put premium plus 10 or 20% of the underlying stock price. So how can he put the premium into a cash market account when he has to keep it as a margin? My online broker will give me less than 1% on my margin account.
And one thing I would be looking forward to: Since this book was written in 2000, it could use an update. Then Eisen could test his strategy with a longer history and real data (he had to calculate backdated data because LEAPS had only been existing for seven years at the time this book was written), and update some of the web sites and bibliographic data.
But altogether this is a great book, and it deserves five stars.

I really enjoyed reading this book. First, it's very condensed and well structured. The author gives a very good overview of stock options, then he explains his strategy (basically it's selling long term naked puts). Because in general selling naked options is considered to be risky, the author explains in details why his strategy is actually a low risk one. He includes the raw data he used, the programs and formulas and the results and their interpretation. The books is written from an individual investor point of view. What I really like about the book is that the author is not trying to avoid or downplay the areas of concerns. Actually he is doing exactly the opposite. He is trying to find and address the weakest points of his strategy and prove his points. Overall, it's a great book to learn about stock options, especially the LEAP puts strategy.

This is one of the most misleading books I've come across. The entire approach developed by the author is based on one assumption - the bull market will continue and it will bail you out. To prove the validity of his approach he selected 1987 - 1997, the greatest bull market in history, when DJI increased 300%. This is the only reason why his strategy "worked." It's hard to believe that a trained mathematician didn't realize that the data he was using was flowed and didn't include a long enough bear market. If he had used a period from 1964 to 1984 instead, his calculations would have shown him a huge loss and this book would have never be published.

For those who are still thinking about trying selling at-the-money LEAPS, I would suggest reading The Black Swan by Nassim Taleb first.

After reading this book I first wanted to give it 2*, but that would not be suited given the amount of work the author has put in this book. The whole document is an illustration of a research project the author has done. He wants to see if it's saver to systematically short put options on LEAPS to view if this gives a better risk/reward ratio than just buying and holding stocks. He uses some criteria to select safe stocks (part of these criteria are stock ratings bij rating agencies). The conclusion of his research was not a surprise to me, nor that impressive.

If this is your first book on shorting put options on stocks you want to own, you might give it a try. The author has very well documented his research in this book, which is somehting very rare in trading books, and he deals with his research question in a scientific way. My only complaint is that this book doesn't offer any help on trading put options/stocks. Nor did I get an insight in how to improve my tactics from this author. I suppose that was not what the author had in mind while writing this book.

Every time I pick up a new investment book, I hope it will have new ideas and insights. Thi sbook really didn't.