LEAPS: A Longer Term Options Strategy

If you find yourself wanting to invest for the long term but don't have enough money to purchase 100 shares of a stock, or if you're bullish on a stock but unwilling to invest too much for too long, LEAPS might be a solution to consider.

However, keep in mind that LEAPS carry additional risks. Therefore, they should only be considered by experienced and financially stable investors.

Today, we are going to dive into the unique options type known as LEAPS.

Short for Long-Term Equity Anticipation Securities, LEAPS are options with expirations usually longer than 12 months. However, options with 10-11 month expirations can also be considered LEAPS.

LEAPS are American-style options and can be bought or sold before the expiration date on certain stocks, indexes, and ETFs.

While LEAPS function similar to regular shorter dated options, there are some differences.

LEAPS are usually more expensive due to their longer expirations, but their time value decays more slowly with time. Additionally, short-term fluctuations in the underlying assets have less impact on LEAPS premiums.

On the flip side, LEAPS generally have lower liquidity and greater bid-ask spread, which is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). Therefore, LEAPS traders should pay more attention to its liquidity and the price when making trades.

To help avoid being trapped by illiquid markets or unfavorable prices, traders may need to be more patient and persistent in their trading approach. For example, rather than bidding at the market price, traders may choose to use the average of the bid and ask prices or test the market with different bids to find a suitable price. This can help obtain a more favorable fill price when trading LEAPS and potentially increase the likelihood of achieving profitable trades.

So, how can LEAPS be used? Let's look at some strategies.

(Note: All the cases are hypothetical and are used for illustrative purposes only. They are not intended to represent the actual results of any specific investment, which can fluctuate in value. Commissions and other charges are not included in any calculations.)

The most commonly-used LEAPS strategy is a long call, which offers an alternative to stock ownership. Let's compare it with buying the underlying stock directly.

Suppose stock X is trading at $123.30. Let's first discuss the strategy of buying a LEAPS call with an expiration of around 14 months. Several factors to consider.

First, Delta, which is the theoretical price movement of the option price when the underlying stock price changes. For example, if an option's delta is 0.8, it means the option price will move by $0.8 theoretically whenever the underlying price moves by $1.0.

Call options with higher delta values tend to be more in-the-money and more consistent with the underlying stock in price change but are also more expensive.

Liquidity is also an important factor to consider for LEAPS, which we have mentioned above.

Investors make choices by balancing delta, price, and liquidity.

Suppose we finally find the LEAPS call with a delta of 0.6403 and a strike price of $115, and the premium cost is the average of the bid and ask of the call, which equals ($23.1+$23.65) /2=$23.375.

Firstly, let's compare this strategy's initial investment with buying the underlying stock directly. Buying 100 shares of stock X costs $123.3*100=$12,330 while purchasing the LEAPS call needs $23.375*100=$2,337.5, which is less than 20% of the former.

Then let's compare the two strategies P&L when the stock price goes up, down, or trades sideways, respectively.

First, suppose the stock moves up after we buy the LEAPS call or its shares.

If we exercise the LEAPS call, we can buy stock X at $115. When adding in the $23.375 premium, the cost of this strategy per share is $138.375, higher than the $123.30 of buying the stock strategy.

But if the stock price rises higher and higher, investors may consider the higher part of this strategy's cost insignificant.

Also, be aware that a LEAPS strategy has an expiration date, but a long stock strategy doesn't. If the underlying price moves unfavorably by the expiration date of the LEAPS, then the higher cost that comes with a LEAPS strategy may expire worthless.

In addition, for options traders, they can consider closing their options position instead of exercising the contracts.

In practice, closing an In-the-Money LEAPS option position strategy before the expiration date usually has a higher profit potential than that of exercising the option. The reason is that the LEAPS call has an time value apart from the intrinsic value. The time value decays relatively slowly, especially when the implied volatility is high.

However, low implied volatility affects the time value, which decays more quickly when it closes to the expiration date.

Second, suppose the stock moves down after we buy the LEAPS call or its shares.

The LEAPS strategy may not work better than the buying stock strategy when the stock price is not below a certain level.

However, imagine the stock price drops sharply, say, to $60.

If we only buy the stock, we're expected to lose ($123.3-$60) *100=$6,330, while the loss of the LEAP strategy will not exceed the net cost of the strategy because the call still has value left, which is $2,237.5, less than 40% of $6330.

If the stock price drops further, it will work more in the LEAPS strategy's favor.

However, a LEAPS strategy has an expiration date, and if the stock stays out of the money by the expiration date, it will expire worthless, whereas someone that's long stock may be able to hold on longer, and the price could potentially rebound in the long run.

There's also the opportunity to earn dividends for certain stocks, which is not the case with options.

Third, let's see how things go when the stock price remains stable.

Excluding other charges, the long stock strategy will break even assuming it's sold. Also, there's no expiration date when holding a stock, unlike with options.

Early on, a LEAPS option experiences minimal time value decay due to its longer-term nature. However, as the option approaches its expiration date, losses may accelerate as the time value decays more significantly. The loss gradually approaches $2237.50.

Finally, let's take a general view.

Compared to the long stock strategy, the LEAPS call strategy limits potential loss when the stock price falls sharply. It has a lower profit potential because of higher costs when the stock moves up or remains stable. And it gets similar long-term investment exposure and potential profits. But without holding the underlying stock, traders of LEAPS are limited by the expiration dates. They might miss out on possible dividend payments.

The LEAPS call strategy also requires lower initial investment and uses funds more efficiently. Because of fewer initial capital requirements, LEAPS could provide a higher return potential than a long-stock strategy. Some investors use LEAPS calls of several stocks to help diversify their portfolios or to set aside funds to invest in other assets or for emergencies.

Some investors replace their LEAPS calls with a new one with a later expiration, and do so repeatedly. In this way, they can track the underlying stock for the long term. This strategy is known as Option Roll Forward. Of course, it involves a higher cost and also realizing any gains or losses when rolling open contracts..

Investors may also use LEAPS calls to track a specific index for the long term.

What else can a LEAPS strategy do?

LEAPS can also be used to hedge downside risks on long stocks, especially in retirement portfolios.

Investors may also sell LEAPS to potentially enhance income or combine LEAPS with other options or stocks.

But like regular options, LEAPS also have risks, including losing all premium paid if a long option expires worthless and facing unlimited risk potential with a short option.

Let's wrap up what we've learned so far.

LEAPS are longer-term options with expirations usually longer than 12 months. Compared to regular shorter dated options, LEAPS are more expensive, but their time value decays more slowly, and their prices are less affected by underlying price changes. However, they usually have lower liquidity and greater bid-ask spread.

Investors may consider a LEAPS call strategy an alternative to stock ownership. This strategy limits potential loss, has higher capital efficiency and return rate potential, diversification opportunities, and the ability to set aside funds for emergencies. However, it may not generate a higher return than the long stock strategy in certain scenarios. Choosing a LEAPS call must balance delta, price, and liquidity.

LEAPS can hedge downside risks and potentially enhance income like short-term options but have similar risks.

Do you have any other ideas about LEAPS? Please share your thoughts with us in the Comments.