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:
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
If share price rises early, short-term options benefit (same example as above)
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.
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.
Contest results to date
% 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:
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.
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%.
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,