Upbeat music plays throughout.
Narrator: So, you have your eye on a stock or ETF that you think is going to climb over the next year and you're not one to shy away from risk. You have choices. You could pay the costly full price for the stock, of course. You could also trade on margin, borrowing against some of your assets to buy the shares, which comes with a cost and additional risks. Or you could use less capital intensive LEAPS call options, which allow you to take a more measured approach with your leverage.
LEAPS, or long-term equity anticipation securities, are equity options with 270 days or more before their expiration date. We're going to focus on calls which give buyers the right to buy the underlying at a certain price by a certain date, but over a much longer time frame.
LEAPS calls can be used as an alternative to holding stock because they increase in value as the stock price rises, but they're a fraction of the cost of buying shares.
On-screen text: Disclosure: Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Animation: A chart compares the price change of two lines. The line for the LEAPS call shows a price change of 102% after about six months and then falls to a return of about 20% before rising to 117%. The stock line shows the stock rising to about 35%, dropping to 15% before rising to 46%.
Narrator: This chart shows why some traders use LEAPS options. The value of this call rose 117% versus 46ish percent on the stock. But notice that the call was much more volatile than the stock, which shows that leverage trading isn't for the faint of heart.
That high upside at a lower cost is why some traders use LEAPS as a stock alternative strategy. We're going to talk about that and other benefits and drawbacks to LEAPS, compare them to trading on margin, and give some considerations for using LEAPS. If you're new to options, please check out some of our basic videos first. Let's get to work.
We'll start with some LEAPS call basics. Like I said before, LEAPS calls work just like other calls. Generally, if the underlying stock rises, the value of the call will increase, and if the stock falls, the call value decreases. The call can also expire worthless, which means you could lose your entire investment.
This also means that the risk profile looks the same as a regular call. So, they theoretically have unlimited upside potential because they can climb as high as the underlying stock does, until expiration. They also have defined risk because you can't lose more than the price of the options contract as long as the option is closed out before expiration.
You may choose to buy a short-term call if you want to try and take advantage of an immediate move, but you may consider LEAPS if you want to trade longer-term moves.
However, there are some downsides when using LEAPS calls as a stock alternative. Call option traders don't receive dividends, have no voting rights, and can't use them for margin trading or loans. Additionally, options premiums lose value due to time decay and can eventually expire worthless. Also, the leverage involved means LEAPS are volatile, which can result in large gains or large losses.
Trading LEAPS calls may seem straightforward, but like other long options strategies, they're complex. Not only do they require you to correctly forecast the direction of the price of the underlying, but you also must predict the time it'll take to happen, though you have more time to work with than shorter term options. In addition, since LEAPs can be very sensitive to changes in implied volatility, it's important to monitor it during the move. In fact, you may be correct on the price movement and still lose money if you're wrong on the other elements.
Let's talk about a few implications you should keep in mind if you're considering diving into LEAPS.
Before buying LEAPS options, you still need to do your regular stock due diligence. This means performing the same fundamental and technical analysis you normally use for evaluating a stock, like analyzing future profit potential, breaking down financial statements, identifying the trend, and so on…
Also, consider analyzing the direction of interest rates as part of your due diligence. You can see the potential effect of interest rate changes with rho, which measures the contract's sensitivity to changes in rates. Long LEAPS calls are rho positive, so if rates increase, the contract may increase in value. Falling rates could reduce it.
Once your due diligence is complete, you can select a contract. An advantage to trading LEAPS over trading on margin is that you can dial up how much leverage you want depending on the contract you choose with the length of expiration and its moneyness.
In terms of picking things like expiration and strike prices, there are a couple things to take into consideration.
First, LEAPS expirations can be up to three years. The longer the expiration, the higher the cost of the contract, which reduces your leverage. All options lose value over time, but the time decay for longer options tends to be slower. An expiration that's longer than how long you plan to hold the contract can help reduce the impact of time decay.
Animation: A meter titled Leverage is paired with an illustrated options table. The leverage increases as the contracts get further out of the money.
Narrator: Second, the deeper in the money a contract is, the higher the cost and the lower the leverage. However, in-the-money options tend to move more in sync with the underlying stock price. So many investors consider calls with deltas, a measure of the options sensitivity to price changes in the underlying stock, between .60 and .80 when trying to balance leverage and stock price correlation.
On-screen text: Disclosure: For illustrative purposes only.
Narrator: Let's look at a hypothetical example. This is the chart you saw at the beginning. When this LEAPS call was purchased, it had 745 days to expiration and a delta of .75. You can see how the call rose and fell with the underlying price. But, because this is a percentage chart, the smaller investment resulted in a much higher return. If you sold to close this option, you'd probably walk away with a profit.
On-screen text: Disclosure: For illustrative purposes only.
Animation: A chart compares the price performance a LEAPS call to the underlying stock. As the stock moved about 5% lower, the call option fell 30%. When the stock rose to a positive return of 15%, the call rose to a positive return of 32%. The stock and the call then turned down to negative returns.
Now, compare that chart to this one of a LEAPS call that didn't perform as well. This call was also 745 days from expiration and had a delta of .70. It was a bit of roller coaster ride at first, but as the stock fell nearly 15% over the year, the call tumbled 57% and change.
LEAPS as an alternative for stock provides different degrees of leverage for aggressive investors looking to amp up their potential returns. But don't forget about the volatility and risks that come with leverage.
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