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Mechanics of LEAPS

LEAPS are long-term options that have expiration dates between nine months and two and a half years out. The term is an acronym for Long Term Equity AnticiPation Securities. Once the expiration date is less than nine months away, LEAPS convert to conventional options. Some covered call writers will buy LEAPS in lieu of stocks and then sell call options on the same underlying security in what is known as a calendar spread. When both the strike prices and expiration dates of the long and short option positions are different, the strategy is known as a diagonal spread. When LEAPS are purchased, the mechanics of these securities are different from those of the shorter-term options we are more familiar with.  This article will highlight these disparities.

 

Why buy LEAPS?

LEAPS are cheaper than stocks so we are leveraging these securities to generate higher returns on our investments (ROI). If we buy a deep in-the-money LEAPS with a delta between 0.90 and 1.00, the option will behave much like its corresponding stock but at a much lower cost. Also, the time value erosion of LEAPS is much less than that of shorter-term options as seen in the screenshot below:

theta and options

Time value decay of LEAPS

 

The time value erosion of LEAPS starts out slowly and linear. As it becomes a short-term option (approaches expiration) the pattern becomes logarithmic and falls off as cliff (right side of screenshot).

 

Disadvantages of LEAPS related to covered call writing

  • Stock owners capture dividends, LEAPS holders do not
  • Requires a higher level of trading approval than stock ownership when using covered call writing
  • We are buying time and must overcome the time value paid for the option, slippage due to wide bid-ask spreads and time value erosion (theta) to make a profit or even break even
  • Available on a limited number of stocks
  • Bid-ask spreads are wide due to the nature of market-makers trying to price volatility so far into the future

 

LEAPS slower time decay when stock price remains the same

 

mechanics of options

Time decay of LEAPS vs Short-Term Options

 

If share price rises early, short-term options benefit (same example as above)

Option expirations and theta

Time value erosion of options when share price rises

 

Short-term options benefit more from a rise in share value than do LEAPS. However, as the short-term options reach expiration, they will be trading near parity ($3.00 of intrinsic value if the stock price is $53.00 for a $50.00 strike) while the LEAPS will still have significant time value component to it.

 

Discussion

Buying LEAPS is the same as buying time. The leverage involved can result in much higher percentage returns but we must overcome the time value cost to buy the security, wide bid-ask spreads as well as time value erosion to generate a profit. Understanding the mechanics of LEAPS is essential before implementing this product into our investment portfolios.

 

Blue Collar Scholar Competition: Great prizes and a worthy charity

Here are the parameters we are using: Two contests running simultaneously with six prizes:

Contest #1: What will be the value of the S&P 500 by year’s end?

Contest #2: In five sentences or less, give your reason(s) for your response (subjective, voted on by the BCI team)

Prizes in each category (total of 6).

Donation to the USO (United Services Organization) of $5000.00 worth of books.

Click on this link for our contest video and entry form.

 

Contest results to date

Outlook

% bearish: 15.0%

% neutral: 15.8%

% bullish: 69.2%

 

Sample Commentary from Dagmar:

Weekly chart of S&P is in an uptrend. The monthly chart is reversing up and resistance is the previous all time high. Usually, from October to December into Christmas market sees an uptrend.

Thanks for the great response we’ve had to this event. Keep those entry forms coming. We allow two per email address and the deadline is November 30th.

 

Next live appearance

I’m taking December off for family time (articles and videos will continue but no travel). Check out the link below for upcoming events thus far booked for 2016:

Events calendar

I am in discussion with other investment groups throughout the country and expect  my 2016 calendar to be fully booked in the very near future. Thanks to all of our members for making this possible.

 

Market tone

Global equity markets declined as China reported more weakness while expectations rose for a Fed rate hike in December. Germany’s slowing growth was related to China’s weakness and increased the likelihood of more European Central Bank stimulus in December. These economic concerns were reflected in a moderately increasing VIX, not a friend of covered call writers but also not a reason to panic. This week’s reports:

  • US retail sales increased by 0.1% in October, below expectations
  • Auto sales fell 0.5% after rising 1.4% in September, differing with industry reports of strong October auto sales of more than 18 million units annualized
  • Core retail sales (excluding autos, gasoline, building materials and food services) rose 0.2% after an upwardly revised 0.1% gain in September
  • US import prices fell 0.5% in October, a larger decline than expected as the strong US dollar and weak global demand continued to push down the prices of imported goods. For the 12 months through October, prices dropped 10.5%
  • The University of Michigan preliminary consumer sentiment index rose to 93.1 in November from 90 in October. The improvement was a result of a stabilizing labor market and low fuel prices
  • Initial jobless claims were unchanged at 276,000 for the week ending November 7th
  • Continuing claims increased 5,000 to 2.17 million for the week ending October 31st

For the week, the S&P 500 fell by 3.63% for a year to date return of (-)1.74%.

Summary

IBD: Uptrend under pressure

GMI: 4/6- Buy signal since market close of October 19, 2015

BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes. Decisions on positions for the December contracts will be made based on market action this upcoming week but expect to be in at least  50% in-the-money strikes until the Fed makes its position on interest rates known.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

22 Responses to “Mechanics of LEAPS”

  1. Rose November 14, 2015 11:23 am #

    Alan,

    When LEAPS get close to expiration are there both monthlys and LEAPS with the same expirations? If yes, would be bid/ask spreads differ?

    Thanks,
    Rose

    • Alan Ellman November 14, 2015 5:21 pm #

      Rose,

      When LEAPS are less than 9 months from expiration they are converted to Monthlys as the January (or further out) option contract is about to be added. Therefore, there is only one contract symbol and only one bid-ask spread. No confusion.

      Alan

  2. Barry B November 14, 2015 10:23 pm #

    Premium Members:

    This week’s Weekly Stock Screen and Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 11/13/15.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and the BCI Team

  3. Alan Ellman November 15, 2015 6:39 am #

    Premium Members,

    You will notice that although we have 19 eligible stocks and another 13 ETFs to consider, none of the stocks were shown in “bold” This is a result of the market decline last week impacting the chart technicals. Many chartists believe that stock price is 70% the result of overall market conditions and why we must use overall market assessment in our management decisions. There are still 5 trading days to expiration of the November contracts which will help guide us in our non-emotional decisions for upcoming contracts.

    Alan

  4. Roni November 15, 2015 3:37 pm #

    Alan,
    thank you for the detailed explanation of LEAPS.
    I have been trying to learn about these trades for some time, and your article is very helpful.

    Roni

  5. John November 16, 2015 10:17 am #

    Hi Alan,

    First of all I’m from the Philippines, and my friends and I have been using your strategy for almost 5 months already and getting some good results. But in the process we encountered a trade that we didn’t expect but we are still bullish on this trade.
    Bought WYNN for 70.91 on November 2, 2015
    Sell Covered Call WYNN 3.69 $71 Expiration November 27, 2015
    Bought Back Call WYNN 0.60 on November 13, 2015
    Price of WYNN is a 62.20

    Question 1: When hitting a double the stock price should fall big so that the covered call price will be down to 20% for the first two weeks. We have three choices and its confusing which one to pick?

    a. wait for the stock to price up again and sell the same covered call price and expiration to hit a double.
    b. sell another covered call with the same time period but lower price target. 70.91 (cost of shares) – 3.09 (profit from the CC) = 67.82 (around this price range to break even). But our thinking is if we always do this then it’s like we will not be earning anything every time this situation happens.
    c. sell another call with the same $71 price but the expiration will be long term let say for 2-3 months to expire.

    Question 2: Let say after 1 month the price of WYNN is 50. Do I just stick to my plan to sell covered calls of WYNN with a 3-4% gain on the trade or should I sell calls on my breakeven price. Selling at breakeven price have an pros (upside potential is big) and downside (ROO is very low).

    Thank You

    Kind Regards,
    John

    • Alan Ellman November 16, 2015 12:59 pm #

      Hi John,

      The type of exit strategy we select is based on overall market assessment and chart technicals. We would take a more bullish approach (hitting a double) if we felt positive about the overall market and the chart technicals have not broken down. In that case, I lean to buying back the option as you did (nice job on that) and looking to re-sell the same option in the same month (too early to roll out). If the stock is under-performing the market and chart technicals are breaking down, I would favor rolling down or closing the entire position.

      I would also ask this question: Are the reasons I used this stock still present? I could not justify using this stock from a fundamental or technical perspective during the noted time frame. You may have had reasons to justify the trade and then can evaluate if those reasons still exist. If not, it’s time for another financial soldier…no loyalty to stocks when it comes to covered call writing and our hard-earned money.

      If the stock moves to $50.00 it should only be a distant memory of a trade that didn’t work out…we all have a few of those…demand the best!

      Alan

      • John November 17, 2015 1:10 pm #

        Hi thanks for the quick reply. I want to thank you because I was able to close my “WYNN” trade before the stock fell even more and I was able to open a “DY” trade which was in your BCI report.

        John

        • Alan Ellman November 17, 2015 1:34 pm #

          John,

          We cannot predict with certainty which direction a stock or the market will take (how many predicted doom and gloom this week after the tragic events in Paris) but we can absolutely throw the odds in our favor.

          Keep up the good work.

          Alan

  6. David November 16, 2015 3:13 pm #

    I recently subscribed to your premium service, and I am learning a lot. I have a portfolio of mostly blue chip stocks purchased with the intention of growing the dividends. A few are oil companies which have been clobbered during the past year. I don’t want to sell them at this low point, as I believe that they will continue to pay dividends and will recover their value eventually. I don’t want to make the mistake of buying high and selling low. Is there a suitable strategy to generate option income when my cost is so much higher than the current price? Thank you–

    • Alan Ellman November 16, 2015 4:49 pm #

      David,

      Yes, this is a strategy I refer to as “Portfolio Overwriting” where we look to increase share value, collect dividends and significantly reduce the chance of early exercise. We write (at least 5%) out-of-the-money calls and circumnavigate around ex-dividend dates as well as roll options prior to expiration when strikes are in-the-money.

      For details, see pages 343 – 348 in the Classic version of the “Complete Encyclopedia…” and pages 341 – 350 in Volume 2 of the Complete Encyclopedia….”

      Alan

    • Jay November 16, 2015 7:03 pm #

      David,
      I have to chime in on this one as testimonial to Alan’s “Portfolio Over Writing” strategy. It is the perfect compliment to dividend stocks you plan to hold. It’s actually my preferred approach to covered call writing. Blue chips also have weekly options so you can write up to but short of earnings and ex-div dates. Then resume over writing afterwards.

      I also hold major oil stock and, like you, have no intention of selling at a cyclical low point particularly with an interest rate hike on the horizon and Middle East tension on the rise. If anything this is a time to accumulate the XLE. – Jay

  7. John November 17, 2015 10:32 am #

    Hi Allan,

    I am thinking of your trial membership, my question is what would be the down aide of writing a covered call option and then doing nothing until the end of the option period, if the price of the stock is down, I would still own the stock and I could keep the premium and then sell another call the following month generating another premium. As long as I own the stock, how could I lose??

    • Alan Ellman November 17, 2015 11:56 am #

      John,

      It is absolutely critical to include position management techniques as part of our option-selling strategies. If we didn’t we would be like everybody else. Here’s how we can lose by not taking advantage of exit strategy opportunities:

      1- We can lose CASH. If share price declines more than the premium generated we are in an unrealized losing position.

      2- We can lose the opportunity to mitigate losses as in rolling down or closing positions that are heading south.

      3- We can lose the opportunity to enhance gains to even higher levels as in “hitting a double” and the mid-contract unwind exit strategies.

      Respectfully but emphatically I suggest you not eliminate this critical skill from your option-selling techniques.

      Alan

  8. Alan Ellman November 18, 2015 5:14 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  9. Alan Ellman November 19, 2015 4:48 pm #

    NKE tomorrow:

    I know many of our members have NKE in their portfolios. After hours, the company announced a share buyback, an increase in its dividend and a 2-for-1 stock split (12/23). Look for a nice pop in share price tomorrow prior to contract expiration.

    Alan

  10. Irving November 20, 2015 5:23 am #

    I have been watching your videos and learning about Covered call writing. I have a question and need some guidance about my current holding. I purchased 1000 shares FB at $79.07 and the sold the $95 covered calls DEC 18’15 for $2.48. Since I have a nice profit, do I roll-up and out roll-up, or just let it get assigned.

    Thank you in advance for your help.

    Irving

  11. Alan Ellman November 20, 2015 12:46 pm #

    Irving,

    As I type FB is trading at $107.46 and the “bid” for the Dec. $95.00 call is $12.70, leaving $0.24 of time value. This means that the option buyer will generate $24.00 more per contract by selling the option as opposed to exercising it..intrinsic value is captured while time value is lost. It is unlikely (although possible) that exercise will occur one month prior to expiration especially since there is no dividend issue with FB.

    One choice you have is to wait closer to expiration and re-evaluate.

    Another approach if you are extremely bullish on FB would be to buy back 5 contracts and not write calls on those 500 shares and leave the other as is.

    Nice trade!

    Alan

  12. Bob November 20, 2015 12:48 pm #

    Hi Alan,

    Do you do the vast majority of your Buy/Writes at the beginning of a new option period or do you open up positions each week of the quarter.

    The reason that I ask is that the last two weeks of the option month we see the most rapid decline in option values. It would seem to me that this would be the least risky period to sell options.

    Thanks for your help and guidance.
    Bob

    • Alan Ellman November 20, 2015 12:52 pm #

      Bob,

      I write my calls within the first 2-3 days of a 4-week contract and within the first 5-7 trading days of a 5-week contract. The reason (as you pointed out) is that theta or time value erosion is logarithmic for near-the-money strikes so at the end of a contract there is very little time value to capture unless we are dealing with a highly volatile stock. Writing early in the contract also allows us more time for exit strategy execution if the need and opportunities arise.

      Alan

  13. Tom November 29, 2015 8:00 am #

    In the example of the stock is an ATM leap option. If you buy a 75 delta leap option ITM how does the intrinsic value effect your calculations?

    • Alan Ellman November 29, 2015 8:02 am #

      Hi Tom,

      Time remaining until expiration will have an effect on Delta. Looking at the same strike, an in-the-money call with longer time until expiration (LEAPS especially) will always have a lower Delta than the same strike call with less time until expiration. It is just the opposite for out-of-the-money calls; the call with a longer amount of time until expiration will have the higher Delta than the option with less time. Have a look at the chart below showing a $60 stock and the arrow highlighting delta of the ITM $50 strike for 3 expirations. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

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