Taking a LEAPS option strategy is a potent, but risky way of magnifying long equity exposure. Here’s the Smart MNE take on what you need to know.
There comes a time when an amateur options trader gets sick of donating their hard-earned money to a hedge fund manager’s Nantucket summer home and decides to try a more sustainable strategy.
While YOLOing risky options trades might itch that gambling urge we all have, it isn’t great for your early retirement prospects. Chances are, you’ll end up like these fine gentlemen from r/WallStreetBets.
Used properly, options can be a powerful tool for speculating while managing risk. Let’s learn about how to trade options responsibly using LEAPS.
What are LEAPS? When would you want to buy LEAPS?
LEAPS stands for Long-Term Equity Appreciation Securities. To understand LEAPS, we have to go back to options basics, specifically call options.
A call option is a derivative that gives the buyer the right but not the obligation to buy 100 shares of a stock at a given price before an expiry date. The option is comprised of several components:
- Premium, or the upfront price you pay for each option contract.
- Strike price, or the price you pay for 100 shares of the underlying stock. Call options can end in one of three ways:
- Out-of-the-money, when the share price remains below the strike price.
- At-the-money, when the share price is exactly the strike price.
- In-the-money, when the share price is above the strike price.
- Expiry date, or the latest date by which you can exercise the option or sell the option to someone else at a premium.
What are LEAPS options then? It’s a deep in-the-money call option with 1-to-3 years until expiry. The price of LEAPS is affected by several variables. In general, there are a few rules:
- LEAPS lose value over time (slowly at the start, then faster as expiry nears) due to theta. Therefore, the further out a LEAPS is from expiry, the more it is worth.
- Fluctuations in the implied volatility (IV) of the underlying stock will affect the value of the LEAPS. Generally, if IV spikes, options get more expensive. If IV tanks, options lose value.
- The delta of the LEAPS can be used as a proxy for how many shares the contract will act as. For example, a LEAPS with a delta of 0.80 is roughly equivalent to holding 80 shares of the underlying stock.
Now you might be thinking: “Tony, I only buy options expiring in a week to YOLO Tesla earnings calls after Elon tweets. Why would I want to buy a LEAPS?” For one, LEAPS provide leverage. Secondly, LEAPS are highly capital-efficient.
Let’s look at a real-life example.
Buying a stock outright vs. LEAPS
Suppose that you had a total of $20,000 in your trading account, and you’re bullish that the S&P 500 will go up in the next two years. A quick glance at Yahoo Finance right now tells me that SPDR S&P 500 ETF (SPY) is trading at $393.89 per share as of May 24, 2022.
Buy the stock outright
With $20,000, you could afford 50 shares. This puts the value of your long SPY position at $19,694. Let’s explore the effect of three possible scenarios after two years:
- SPY increases by 20% to $472.67. Your new position value is now $23,633.5. Awesome.
- SPY decreases by 20% to $315.10. Your new position value is now $15,755. Not as awesome.
- SPY trades flat and ends up exactly at $393.89. Your new position value is still $19,964 (minus a 0.09% annual expense ratio).
Buy a LEAPS contract
Let’s go through how to buy a LEAPS. I picked a deep in-the-money call with at least two years until expiry. This one’s a $205 strike call expiring December 20th, 2024.
I paid a premium of $198.03 per option ✕ 100 shares per contract = $19,803.
In the previous example, we were only able to buy 50 shares of SPY with our $20,000 account. Now, we’re able to control 100 shares of SPY while putting up the same amount of money.
Now let’s look at our scenarios again by the December expiry date (results assume that implied volatility remains flat; more on this later).
1. SPY increases by 21.86% to $480 per share. Our options contract would have a profit of $7,677, or a 38.9% gain. If SPY increased to this price before the expiry date, our gains would be higher, since theta would have eaten away at the value of our LEAPS less than what it would be close to expiry.
2. SPY decreases by -23.84% to $300 per share. Our options contract would have a loss of $10,303, or a -52% loss. For a 100% loss of the premium we paid ($19,803), SPY would have to close on our expiry date under $205 a share. In that case, our LEAPS would be out-of-the-money and have little value left at expiration due to theta.
4. SPY trades more or less flat and gains just 1.55% to trade at $400. Our options contract would incur a loss of $303, or a -1.53% loss. Even though our option expired in-in-the-money (SPY closed above the $205 strike), theta ate away at the value of our LEAPS somewhat, leaving a slight loss.
- When SPY went up, our LEAPS made more profit compared to holding SPY outright.
- When SPY traded flat, our LEAPS underperformed very slightly.
- When SPY tanked, our LEAPS lost more value.
Frequently asked questions about LEAPS
What are the risks of LEAPS?
LEAPS provide leverage, and it can work against you if the underlying asset tanks. There is always a risk of your option expiring out-of-the-money and worthless. In this case, you lose the premium. To mitigate this, try and go as deep in-the-money as possible and buy LEAPS on broad-market indexes.
Theta is also a problem. Remember, options decay in price over time. This isn’t much of an issue with LEAPS early on, but later theta will eat away more at your option’s value and accelerate as expiry draws near. To mitigate this, always buy LEAPS with at least two years until expiry, and consider rolling your LEAPS out to a later expiry date once just under a year remains. Once you’re ready to take profits, simply sell your LEAPS.
Recall that the price of an option is also dependent on the IV of the underlying asset. If IV drops, your options can lose value even if the underlying stock moves in the right direction (called volatility crush). A good rule is selling options when their IV rank is high and buying when it’s low. IV rank tells us whether IV is high or low for an option based on the past year of IV data.
Finally, some options aren’t very liquid. Even for highly traded index ETFs like SPY, further-dated contracts in the options chain can have wide bid-ask spreads. If you use a market order, you stand the chance of losing money to slippage. To mitigate this, use limit orders in the mid-point of the current bid-ask and wait patiently for a good fill.
How are LEAPS taxed?
Profits from LEAPS are taxable like any other investment income. Depending on how long you held the LEAPS before selling, if you (hopefully) made money, there are now two possibilities:
- If you hold the LEAPS for at least a year and a day, you’ll be taxed at the long-term capital gains rate (0%, 15%, or 20% … and don’t forget about the 3.8% net investment income tax if you’re making $200k+ as a single filer).
- If you hold for any period shorter than that, you’ll be taxed at the short-term capital gains rate (your ordinary income tax bracket, up to 37%).
Tell me a LEAPS horror story?
This brilliant investor (with a rather apt username too) bought a total of 3,378 LEAPS on Palantir Technologies (PLTR), expiring on January 23rd, 2023 at the $22 strike price.
He bought the calls in October when PLTR was trading around $27 per share, making two mistakes here. Firstly, seven months is way too short for LEAPS, especially on a volatile stock like PLTR. Secondly, a strike of $22 vs. a share price of $27 is about as deep in-the-money as a kiddie pool.
At the time of writing, PLTR trades at just $7.55 per share, leaving his call options heavily out-of-the-money. The results? A -97.81% loss from $2,566,540.98 to just $57,426. Ouch.
The final word on LEAPS
Implemented properly, LEAPS can be a useful tool for speculation, capital efficiency, and leveraged investing. Used poorly, LEAPS can wipe out your capital. As with any derivative, proper risk management and monitoring of your position is a must. Have a plan for taking profits or cutting losses, and stick to it.