How would you like to take advantage of the long-term investment benefits offered by stocks at a reduced price tag? If so, then consider investing in LEAP options.
LEAP options (or LEAPs) are option contracts that expire at least one year from the date of purchase.
The acronym LEAP stands for “Long-term Equity Anticipation.”
LEAPs are more affordable than stocks because they’re offered at option contract prices. They’re long-term investments so they give you plenty of time to take advantage of stock price movements without the high cost of the underlying securities.
In this guide, I’ll go over LEAP options so you can determine if they have a place in your trading strategy.
Playing the Long Game
Many traders often buy or sell options that expire within the next month or two. Although that kind of a strategy can offer some significant returns, it also gives the underlying stock very little time to move up or down.
LEAP options solve that problem with a contract expiration that’s at least a year out. The stock has a longer time period to follow the trend line that you predicted and ride out day-to-day price swings.
Unfortunately, LEAPs more expensive than short-term contracts for precisely that reason. You’ll pay a premium when you invest in LEAPs.
That shouldn’t matter if the stock moves in the right direction. The price of the option contract should increase accordingly.
Calls or Puts?
If your outlook for the underlying stock is bullish over the long haul, buy call options.
On the other hand, if you think the price could drop precipitously over the next year or so, buy put options.
The good news is you aren’t limited with LEAPs. You can buy either call options or put options.
Don’t Ignore the Greeks
When it comes to options trading, the pros pay attention to the Greeks. You should, too.
If you’re unfamiliar with the term “the Greeks,” it refers to a set of stats about any option contract. Those stats are identified by Greek letters.
Key in on two Greeks in particular when investing in LEAP options: theta and delta.
Theta measures time decay. The closer an option contract gets to expiration, the more it loses value. That’s especially true if it’s out of the money.
Keep in mind: theta also accelerates as the contract gets closer to expiration. In other words, the day-to-day time decay during the last week of the contract will exceed the day-to-day time decay when the contract still has months before expiration.
That’s why theta won’t affect LEAPs that much initially. However, time decay will become painfully noticeable as the contract gets closer to expiration.
Bottom line: it’s a great idea to buy LEAP options that are likely to spike in value well before expiration. That way, you won’t have to worry so much about theta.
The other Greek, delta, is one that you should look at closely before buying a LEAP.
Why? Because it measures how much the price of the option swings in relation to the price of the underlying stock.
A delta of .80, for example, means that the option price will rise 80 cents for every dollar that the stock price rises.
When you buy LEAPs, look for options with high deltas. That way, your investment will increase in value on an almost dollar-for-dollar basis with the underlying stock.
Read Also: How does the bull call spread strategy work?
In-the-Money or Out-of-the-Money?
If you’re unfamiliar with the phrases “in-the-money” and “out-of-the-money,” they refer to the price of the underlying stock in relation to the option contract’s strike price.
Call options are in the money when the strike price is less than the stock price and out of the money when the strike price is more than the stock price.
Put options are in the money when the strike price is more than the stock price and out of the money when the strike price is less than the stock price.
If you’re into a speculative trade, feel free to buy out-of-the-money LEAP options. Just keep in mind that you’ll pay a hefty premium compared to short-term contracts and the underlying stock will likely to need to move your way significantly before you see a decent return.
As a rule of thumb, in-the-money options have higher deltas. That’s why they’re a great choice for LEAPs.
Of course, in-the-money options are more expensive than out-of-the-money options because they’ve already “arrived.” But options that aren’t too far in the money are still much cheaper than the underlying stock.
Real-Life Example Using a LEAP Option
Let’s say Apple is trading at $175 per share. You think it’s going up significantly over the long term, so you decide to buy a LEAP option.
The $170 call option for a year out is currently trading for $24.00. You believe that Apple is going up at least $30 per share before the contract expires, so you think it’s got potential.
You check out the Greeks. That contract has a delta of 0.63. That means for every dollar that Apple stock increases in value, the option will increase 63 cents. That’s acceptable because you also know that delta will increase as the stock price increases.
The theta is -0.04. That means the option will lose 4 cents in value every day, all other things being equal. That’s also acceptable.
You buy the call option for $24. That means you spend $2,400 because options are sold in blocks of 100 shares ($24 x 100 = $2,400).
Sure enough, after several months, Apple reports record earnings and the stock price shoots up to $198 per share. The option you bought is now worth $41. You sell the position for $4,100 ($41 x 100).
That means your return is a whopping 70%!
Now compare that to what you’d get if you bought 100 shares of stock. You’d pay $17,500 ($175 x 100) for the position and sell the stock for $19,800 ($198 x 100). That would give you a return of just 13%.
So if you bought the stock you’d invest a lot more money for a much smaller return.
That’s what makes LEAP options attractive to so many traders.