LEAPS: QUICK TAKES
- LEAPS are option contracts with more than a year to expiration
- Functions similar to buying or shorting up to 100 shares of stock
- LEAPS have low exposure to theta-decay and high exposure to implied volatility
- LEAPS can act as cost-effective hedges for long-term portfolios
- Because the ‘S’ is part of the acronym, you don’t buy “a LEAP”, you buy “a LEAPS” — we know, it feels awkward.
What are LEAPS?
Long-term equity anticipation securities, or LEAPS, are option contracts with more than a year to expiration. LEAPS function similar to buying or shorting stock, with defined-risk and much lower capital requirements.
You can look at your total delta as a proxy-measure of the share equivalent of your position. If you have, for instance, -80 delta, that’s a bearish strategy that will have similar effects to shorting 80 shares of stock.
While all long options are subject to time-decay, LEAPS are relatively resistant to theta’s pull. Time-decay will still occur, but it will generally be a very slow process until about 60-days to expiration.
Additionally, if held for more than a year, LEAPS can allow the holder to claim profit as long-term capital gains rather than short-term — meaning a far lower tax rate (so long as they’re held for the minimum duration).
When to Buy LEAPS
Though they have low sensitivity to theta, LEAPS are highly sensitive to changes in Vega. If implied volatility moves higher, the extrinsic value of LEAPS will increase, accounting for “what could happen” as volatility rises. Conversely, as implied volatility moves lower, the extrinsic value of LEAPS will decrease. That means timing your purchase of long-term equity anticipation securities in accordance with volatility levels is highly important.
For instance, imagine a massive shockwave sends a particular stock plummeting. You believe the stock will recover by next year. If you buy call LEAPS immediately following a huge price move, you’ll likely be buying when implied volatility is high. Translation: You’re probably going to overpay for that option. It’s best to buy LEAPS when volatility is low. Otherwise, the stock could move in your favor, and you could still lose money if vega drops significantly.
The good news: There is a way to negate some of that implied volatility risk when buying LEAPS… (more on that later).
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Three Strategies for Trading LEAPS
Use LEAPS as a cost-effective hedge against a larger portfolio
Trying to time potential downside in your long-term portfolio can be difficult and time consuming. Shorting stock exposes you to unlimited risk, potential margin calls, and requires a high amount of collateral. Using LEAPS for hedging purposes addresses all of these issues.
For instance, if you have a portfolio that is heavily allocated towards technology, you can use QQQ ETF put LEAPS to hedge against a potential downturn. Alternatively, you could target a specific name in the space that you feel is in a particularly weak position, or that has a very high beta (high beta means big reactions to macro market movements.)
Use LEAPS as part of a stock replacement strategy
Stock replacement is one of the most common ways that traders use LEAPS. The biggest benefit of stock replacement is the lower cost. Let’s look at a real life example.
Imagine you want long exposure to 300 shares of Apple, which currently costs $162.88.
You could buy them outright, for a total cost of $48,864 — slightly higher than the cost of a 2022 Tesla Model 3.
OR, you could buy 4 AAPL call LEAPS at the 75 delta, giving you 300 total delta exposure. Currently, the $135 strike January 2024 AAPL calls have a delta of just over 75, and cost $43.80 each. So the stock-replacement equivalent to being long 300 shares of Apple in this case is $17,520 — knocking more than $30,000 off the price tag.
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Along with this lower cost comes the potential to hold more cash, which ultimately means more opportunity. However, stock replacement isn’t fool proof — the downside of the above example is that if Apple trades below the strike price on the expiration date, those options could be at risk of expiring worthless.
However, a nimble trader can mitigate this risk by rolling or adjusting the option if needed. While the possibility exists for larger-than-usual downside price swings, so too does the opportunity exist for larger-than-usual upside price swings. If $AAPL moves swiftly to the upside, the total delta of the trade will increase, leading to a larger “share equivalent”.
One more drawback to the stock replacement strategy is the additional extrinsic value you’re forced to pay for when buying long-dated options. In the example above, the options have an intrinsic value of $27.88 each ($162.88-$135.00), and an extrinsic value of $15.92. That means if $AAPL stays exactly where it is, never moving between now and the January 2024 expiration, these options will lose $15.92 each. In the same scenario, shares would not lose any value.
However, there is a way to mitigate that extrinsic value, and to negate some of the effects that vega has on LEAPS…
Use diagonal spreads to purchase LEAPS at a lower cost-basis
Even though they’re more cost effective than buying 100-lots of shares, LEAPS can still be rather pricey. And on top of that, if implied volatility is running hot, it may not be the right move to buy LEAPS on their own. However, we teased above that there’s a tactic traders can use to negate some of that risk. The tactic: Diagonal spreads.
Market Rebellion’s Chief Technical Analyst AJ Monte uses diagonal spreads all the time to lower the cost basis of his option LEAPS while collecting premium. How does it work? By selling further-from-the-money, shorter-dated options with the same directional bias against your long-term position.
For instance, in January, AJ picked up January 2024 put LEAPS at the $225 strike in the IWM Small Cap ETF. This would have cost $34.50. However, AJ lowered the cost basis by $4.00 when he sold January 2023 put options (which were just a few weeks from expiration) at the $210 strike against his $225 put. This is a defined risk strategy. If the IWM plummeted below his $210 strike on expiration, the worst case scenario is that the trader would be forced to sell both options — and the longer-dated, higher strike put option will always have a higher value.
In his Options Oracle service, AJ has continued to repeatedly sell IWM puts against his put LEAPS, lowering the cost basis by more than 30%. All the while, the value of those same LEAPS have increased by more than 20%!
The Bottom Line: LEAPS are pretty straightforward, but as with anything in options trading, a little knowledge goes a long way in fine-tuning your strategy. Whether you’re trying to collect premium, replace long stock, or hedge a portfolio, consider using option LEAPS to do it.