Options, LEAPS and Warrants

Adam Hamilton
Archives
Sep 26, 2007

Excerpt from the July issue of Zeal Intelligence, reproduced with permission.

The high-risk high-reward world of options is a heck of a lot of fun for speculators, especially during uplegs. But during long grinding consolidations like today; losses in options start to mount as the upleg continues to evade us out in the future. Time is the mortal enemy of speculators playing this options game on the long side. With options trades typically running for six months or so before expiration, if the price of the underlying stock has not moved far enough within these six months then the trade is a loss. Such a small margin for error in conventional options timing makes it an exceedingly risky and unforgiving game. But for the price, there are little known trading tools that offer speculators much more time.

Options, LEAPS and Warrants

In 1990 the CBOE introduced LEAPS (Long-Term Equity Anticipations Securities). These are just long-term options. While technically LEAPS can run for up to three years, it is more common to see them running from 1 to 2 years out to expiration. This is 2x to 4x as long as the typical duration of a stock-options contract, which grants traders more time for their bullish trading theses to prove correct. LEAPS can be traded just like a normal option in any option enabled stock trading account. While we haven't traded LEAPS at Zeal in the past, I suspect we will in the future. Especially in times like today in long consolidations where the end and next upleg is probable, yet still remains out of sight. Most of the big commodities stocks as well as many of the mid-tier ones already have LEAPS traded on them. GDX does too. When you are looking at an options chain, you can tell by the symbol if a particular strike is a LEAPS or normal option. While normal options symbols start with the underlying stock symbols, LEAPS start with a letter late in the alphabet like V or W that represent their expiration year. LEAPS, like options, are a zero-sum game. When you win the option writer loses dollar-for-dollar. So since LEAPS give you extra time to be right, they also cost considerably more to fairly compensate the options writer for his additional risk. You simply cannot get something (time) for nothing in the financial markets.

While options and LEAPS are side games mostly run by the CBOE and independent of the underlying stocks, sometimes companies themselves issue very long-term options. These are known as warrants and have expirations running 3 to 5 years in most cases. Warrants can be issued alone, to raise capital, or to sweeten bond offerings. From a company's perspective, warrants sales bring in cash today without diluting outstanding shares until the future when the new warrants are actually exercised. For traders they offer long-term options exposure with tons of time to be proven right.

Commodities - Stock Warrants

Publicly-traded warrants have been around for decades, maybe centuries, yet few traders are aware of them. I have to admit I had not thought about them since I learned about them in college finance classes. Then in early 2005, Dudley Baker came along. Mr. Baker, who I am very blessed to call a friend, had been trading all kinds of derivatives since the 1970's commodities boom. He wanted to trade warrants on his favorite stocks, but couldn't find information on what was available in warrant terms. So he started his own database on PM-stock warrants to chronicle his personal research for his own trading. In early 2005 he decided to share his awesome database and ongoing research in a fantastic service that I highly recommend if you are interested in warrants. It is Precious Metals Warrants. Mr. Baker is now the world's premier commodities-stock warrants guru. As far as I am concerned, he has achieved near omniscience in this fascinating realm. Over the last couple of years, he has taught me much about warrants and greatly expanded my perceptions of the great array of warrants available for traders. [Editor's note: You can signup for Dudley Baker's free weekly email, The Warrant Report, here.]

In many ways warrants are the most unique trading tool of all. A warrant that expires 5 years from now is like some kind of stock-and-option hybrid, combining some of the best attributes of each in a secular-bull environment. Like a call option, a warrant gives its owner the right but not obligations to buy a stock for a certain price for a certain period of time. Since warrants are cheaper than owning stock outright, you can use warrants to increase leverage or decrease risk. To get more leverage, take capital you are going to use to buy a long-term stock position and instead buy warrants, which lets you 'control' the profits on many more shares. To lower risk, use less capital than it would take to buy stock to buy warrants on the same number of shares. Like any options if you are wrong you will take a loss of up to 100%, but within a secular bull it is hard to be wrong over such a long period of time. The odds of winning for warrants are vastly higher than in standard options due to this abundant time.

Warrants are fairly easy to trade too. Most trade just as any stock does, but often on the Canadian exchanges or in the US Pink Sheets. In some cases warrants have symbols not recognized by online trading systems. For these, all you have to do is call up your broker, give him the CUSIP number for the warrant, and he can make the trade for you. As these are long-term holdings, this is not a big deal since you do not have to trade them very often at all. Largely thanks for Mr. Baker's comprehensive warrants database, I'm going to be integrating warrants into my own personal portfolio as well as our ZI trading. They are a unique trading tool that is highly underappreciated and potentially incredibly profitable.

Adam Hamilton, CPA
Excerpt from the July issue of Zeal Intelligence, reproduced with permission.

You can sign up for Adam Hamilton's Zeal Intelligence subscription service here. Adam Hamilton email: zelotes@zealllc.com. You can sign up for Dudley Baker's free weekly email The Warrant Report here. Dudley Baker email: info@preciousmetalswarrants.com.

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