Check out a LEAPS Diagonal Spread

April 3, 2012

Randy Frederick
Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Interested in generating some short-term income with an options spread? Consider using LEAPS in a diagonal spread—a long and short position in options of the same type (calls or puts) but with different strike prices and different expirations.

How does it work?

Because the long leg of a LEAPS diagonal call spread is a call option with many months until expiration, you have the right to exercise the call at any time (up until expiration) and buy the underlying stock at the strike price. Typically the owner of a LEAPS option would sell it in the market rather than exercising it, because the time value would be lost if it is exercised.

Additionally, as you've sold a shorter-term call option, you have taken on an obligation to sell stock at the strike price to the long call holder (if you are assigned) at any time up until expiration of the short call. If the short call expires in the money, you would need to purchase the stock in the market to cover the short stock position created by the assignment, and sale proceeds from the long LEAPS call will generally result in the strategy being profitable.

What are LEAPS?

LEAPS are options that expire much later than traditional options. Traditional options expire in nine months or less. LEAPS, on the other hand, can potentially expire up to about three years in the future. And while approximately 3,000 stocks trade options, only about 800 trade LEAPS. However, almost all the largest and most actively traded stocks have LEAPS.

How do I set up a diagonal spread?

When you select your in-the-money LEAPS call option, you have to decide how far in the money you are willing to go. Deeper in-the-money options will cost more but they will also behave a lot more like the underlying stock. All options have delta, which estimates how much the option price changes relative to the underlying stock's price change. A slightly in-the-money call option with a delta around .60 will cost a lot less than a deeper in-the-money option with a delta around .80, but it will only increase theoretically about $0.60 for every $1.00 increase in the price of the stock. A call option with a .80 delta should increase about $0.80 for ever $1.00 increase in the price of the stock.

Delta is also a real-time estimate of the probability of a particular option expiring in the money. So if you purchase a long LEAPS option with a delta around .80, at that moment, the estimated probability of that option expiring worthless is only about 20%. This is not to say that you will earn a profit. But there's a greater probability that your option will have at least some value at expiration.

Let's look at an example.

Diagonal spread example

Assume XYZ is currently trading at a price of 72. It's January 2012 and you buy 10 XYZ 01/19/2013 40 calls @ 35.85 (yellow circle), and sell 10 XYZ 04/21/2012 75 calls @ 2, providing approximately two points of immediate downside protection. Using the Theoretical tool (blue circle) within the options chain in StreetSmart Edge®, you can estimate how much your options will change in value relative to XYZ.

Theoretical Tool in StreetSmart Edge

Source: StreetSmart Edge.

Because the long LEAPS calls you purchased (which expire in 12 months) are deep in the money, they have an initial delta of approximately .90 and will decline in value by approximately $0.90 if the stock immediately declines $1.00. However, delta is a continuously calculated value and it typically decreases as the price of the underlying stock decreases. After another $1.00 decline in the price of XYZ, the LEAPS will likely only lose about $0.89 (red circle). If XYZ dropped about $2.00 immediately (pink circle), your long calls should drop to about $34.01 (green circle) or about 1.84 points.

Keep in mind that the long LEAPS option includes 3.85 points of time value (the option is 32 points in the money) so if it took XYZ a couple of months to drop two points, you would likely end up with a little less than two points of downside protection due to time value erosion. Long options lose value over time.

Theta is a measure of this time decay. In this case, the Theta (brown circle) indicates that this option will lose about $.01 each day even with no price change in XYZ.

While your total risk is limited to 33.85 points (2 – 35.85) or $33,850, if XYZ drops to 40 or below by January 19, 2013, your long LEAPS will expire worthless and the maximum loss will be incurred.

Diagonal LEAPS Example

Source: Schwab Center for Financial Research.

As you can see in the table above with the LEAPS diagonal spread:

• The initial cash outlay is $33,850 
• At prices above the short strike price, it is possible to earn a profit margin of up to 9.3% 
• But when the underlying stock declines, losses will be incurred 
• If XYZ declines substantially, both options could expire worthless

What are the benefits and risks?

I think LEAPS diagonal spreads are a good illustration of the double-edged sword called leverage. Therefore I'd like to conclude with some final cautionary points regarding this strategy.

Benefits:

• If the underlying stock is below the strike price of the short option and it expires worthless, subsequent short options can be sold for later months, lowering the overall cost basis even further.
• If the short option expires in the money, the remaining value of the long LEAPS call should be more than enough to cover the difference between the assignment and market prices.

Risks:

• If the price of the underlying stock drops substantially prior to the expiration date, your LEAP position will lose value and could become completely worthless.
• If your short calls go in-the-money, you could be assigned at any time.
• While this strategy does limit risk somewhat, it cannot eliminate it entirely. Losses are limited only by the amount of premium you received on the initial sale of the short option, but time erosion is working against you on the long option.
• Unlike stock owners, owners of long options do not have voting rights and are not entitled to receive dividends (if any).
• LEAPS are options so they eventually expire.
• To utilize this strategy, you have to be approved for spread trading (level 2 at Schwab), and you must have a margin account.

For additional information on this strategy or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

LEAPS® and Long Term Equity AnticiPation Securities® are registered trademarks of Chicago Board Options Exchange.