Although we generally prefer to trade shorter duration option contracts here at Option Alpha, contracts a couple of weeks to a couple of months out from expiration, there’s a whole other classification of options contracts for traders that want to take longer-term exposure or positions. Long-term equity appreciation securities, or “LEAPS” as they are lovingly referred to, help to nicely combine the need for long-term investing exposure with the flexibility and leverage of options contracts.
What are LEAPS Contracts?
- LEAPS, or Long-term Equity Anticipation Securities, are publicly traded contracts with an expiration date longer than one year.
- They behave exactly the same, given all the environments and timelines, as shorter-term option contracts but have longer maturities.
Benefits/Reasons to Use LEAPS Contracts
- LEAPS give investors who don’t want to trade shorter-term contracts exposure to much longer time horizons.
- LEAPS reduce capital exposure right off the bat and still gain a meaningful position in the underlying equity.
- Even with reduced capital exposure, we also have dramatically less downside risk. If the stock crashes, you can only lose the amount of money that you put out, not the total value of the contract or stock going to zero.
- You keep nearly all the upside potential that you had in the original stock shares if you were to use LEAPS as a synthetic.
- You can use LEAPS contracts in conjunction with other options strategies to reduce risk, hedge a position, or to reduce the cost basis in the LEAPS contract.
Example 1: Using LEAPS for Tesla Stock.
- We use Tesla as an example because of its volatility.
- Tesla is currently trading at $742 a share. If you buy 100 regular shares, taking on $74,200 of risk, and Tesla drops 50% overnight (don’t say it’s not possible), you cut your position in half.
- We can alleviate the risk using a LEAPS contract, and buying deep in the money call option, going out one year or two years and synthetically replicate the stock position on Tesla. But, a position like this involves a compromise.
Considerations in the Tesla Example: Roll Price and Deltas
- How far out you go will become increasingly expensive the more time you want to protect.
- Thus, if we buy official LEAPS contracts for Tesla 410 days out to expiration, the $740 strike price is worth $20,400. Add another year and that becomes $25,000. There is a roll price to be considered when rolling from one year to the next.
- The next consideration is at what strike price to buy these contracts. This can be done using Deltas, an approximation for how many shares that contract will act as for the underlying stock.
- If you buy 100 shares, you participate in the full move if a stock goes up by a dollar, but if you buy a LEAPS contract with a 50 delta, and the stock goes up, you only participate in half the move.
- Thus with deltas, you wave capital exposure and potential downside risk but in exchange, you don’t fully participate in the upside moves.
- A 70 or 80 delta is wise if you’re buying a LEAPS contract if you truly want to replicate the synthetic nature of the stock.
Example 2: Buying Tesla Using an 80 Delta Call Option.
- In our example with Tesla, let’s say we use an 80 delta call option for the June contracts, which are 410 days out versus outright buying stock.
- So, using round numbers, with Tesla trading at $740 and we buy 100 stocks, that’s $74,000. If we buy the 80 delta, (replicating roughly 80 shares compared to the 100 shares of stock), the strike price is $520, costing $31,000.
- Compared to the $74,000, the LEAP $31,000 is cheap, but what are the trade-offs?
- Exposure in Tesla beyond expiration.
- The $520 strike price, plus the $310 cost of the contract itself gives a break-even price of $830 at expiration. Tesla has to be above $830 at the LEAPS expiration in order to make money.
- I.e., we don’t outlay $74,000, only $31,000, and in exchange for only having half the capital at risk, we give ourselves an opportunity to make money, but only above $830.
Example 2 Continued: What to Do in Conjunction with LEAPS Contracts Before Expiry.
Create a wide bullish spread.
- We could sell the $900 strike call options for the same June contracts of 2021, creating a wide bullish spread in Tesla. This reduces the cost down to $165 versus $310 for the contract in the previous example, reducing the total cost of the position to just $16,000. This makes the break-even price of the Tesla stock only $685 now.
- We reduce the capital required to get into the position in exchange for curbing our profit potential.
- The trade-off is giving up everything above $900 in profit potential.
Sell covered calls in a closer expiration month.
- Let’s say we went out to the June contracts that are 46 days from expiration and we sold a covered call on Tesla with a 30 delta right now, which is a strike price of $880, for a $32 premium.
- This $3,200 starts to slowly chip away at our cost basis on the LEAPS contract that we purchased if we do this every month.
Understanding the Downside Risk of these Strategies
- If you get into the stock position, the downside risk is if the stock goes to zero.
- If you buy the deep in the money call option at the 80 strike that cost $31,000, that’s your max risk on the call option side. If Tesla goes way down, your risk is capped with any move below 520. The trade-off here is giving up the upside potential, though.
Why don’t we trade LEAPS all the time?
- If volatility contracts, it’s not going to be good for these contracts.
- LEAPS contracts are also impacted severely by interest rate changes. Just like they have an impact on the shorter duration contracts 20, 30, 60 days out from expiration, the impact is magnified the further out you go.
- Interest rates are important because they relate to the cost of carrying a position or hedging a position. We can use rho (similar to delta) to measure the option’s sensitivity to interest rate changes.
- LEAPS serve their purpose and are a wonderful tool but need to be understood and analyzed in terms of their benefits and trade-offs.
- If you’re going to trade longer-term expirations, you should do more analysis.
Option Trader Q&A w/ Dylan
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Dylan:
My question is with a small account, how do you keep each position 1% – 5%? For example, let’s just say I have a $10,000 account. If I want to size my position to 1% – 5% of my $10,000 account it would be equivalent to $100 – $500 per position. For example, if I want to sell a 13.5 put and a 15 call USO strangle, it would require $1,500 buying power reduction. If my account is $10,000, this strangle would be equivalent to 15% of my portfolio and this is just one position. Now, even if I raise capital and have a $20,000 account, it still would not work. If I were to sell the same 13.5 and a 15 USO strangle, this position alone is 7.5% of my $20,000 account. What’s even worse is this position would give me only 49 cent credits. Please help me understand this nightmare. I hope that you can point me in the right direction and thank you for all the work that you have done and have a great day.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.