If you are like most people, you have heard of LEAPS options but don’t know what they are. In this article, we will discuss the two most important factors that you need to know about LEAPS stock options!
We will discuss:
- What are LEAPS options?
- How does the LEAPS Option Strategy work?
- LEAPS Options vs Buying Stocks Outright
- When is the best time to use the LEAPS option strategy?
- The two most critical factors when buying LEAPS options
- How do we put on a LEAPS option trade? LEAPS Option Example
- How do we manage the LEAPS option strategy?
- Conclusion
What are LEAPS options?
LEAPS options are long-term options that have an expiration date that is further out than traditional options. The name “LEAPS” stands for “Long-Term Equity Anticipation Securities.” LEAPS options were created in 1990 to give investors the ability to trade options within a longer time frame.
How does the LEAPS Option Strategy work?
The LEAPS Option Strategy is a great way to get involved in the market without having to tie up a lot of capital. When you buy LEAPS options, you are paying for the right to buy a stock at a set price (strike price) at some point in the future (expiration date).
LEAPS Options vs Buying Stocks Outright
When you buy LEAPS options, you are paying for the right to buy a stock at a set price (strike price) at some point in the future (expiration date). When you buy stocks outright, you are paying the full market price for the stock and own it immediately.
Buying LEAPS options allows you to control a larger number of shares for less money upfront. The cost of the LEAPS option is the maximum amount of money that you can lose if the stock price goes down. So buying LEAPS is a defined-risk trade. Buying the stock outright costs much more upfront and is also riskier since you can lose much more if the stock moves down in price.
When is the best time to use the LEAPS option strategy?
The LEAPS Option Strategy is most effective when you are bullish on a stock and expect the price to rise over the long term.
A down market or bear market is often a great time to start buying LEAPS options. This is because stock prices are usually depressed during these times and you can get a great deal on LEAPS options.
The two most critical factors when buying LEAPS options
are: Time value and intrinsic value
Time value is the amount of time until the expiration date of the option contract. The longer the period until expiration, the higher the time value. We will also cover Time value and going more than 1 year and closer to 2 years out when we discuss another way to manage LEAPS options
Intrinsic value is the difference between the strike price of the LEAPS option and the current price of the underlying stock. If the stock price is below the strike price, then there is no intrinsic value.
When buying LEAPS options we want to go deep in the money and as far out in time as possible. The best way to demonstrate why is to show you on the Tastyworks platform.
How do we put on a LEAPS option trade? LEAPS Option Example
Let’s take a look at buying a LEAPS option in PLTR Palantir. It is a solid stock expected to grow but has been caught up in the overall move down in growth stocks in the market. The stock price is currently 10 and it has been as high as up as high as 29 just within the last year.
So we go 547 DTE days to expiration and the January 2024 Call options. We go this far out in time so that we have plenty of time for the stock to increase in price.
We pick the deep-in-the-money $5 strike since it has $5 in intrinsic value. In other words, with the stock currently at $10, there is already $5 in our favor built into the trade. So we can really look at it as costing just $1.10 which is the $6.10 cost to put on the trade minus the $5 intrinsic value built in.
This is a great deal because the stock only needs to move up $1 before we start making money. And at this point it closely replicates owning 100 shares of Palantir.
If the stock gets back to the $29 where it was at in Sept, then we make about $1800 or ($2900 – $1100).
How do we manage the LEAPS option strategy?
There are different theories on managing LEAPS Option trades. I will give you a couple of different methods that are commonly used. Then I will tell you what I like to do.
The first method is to set a price target for the stock and sell the LEAPS call option when the stock hits your target price. This will allow you to lock in your profits and avoid letting the trade run against you.
The second method is to hold the LEAPS call option until it expires. This is a more aggressive approach and it can lead to bigger profits if the stock continues to go up in price. But it also carries more risk because you are letting the trade ride.
I like to use a combination of both methods. I will set a price target for the stock and hold on to the LEAPS call until it hits my target. But I will also sell half of my position at my target price to lock in some profits. This way, I have some downside protection if the stock reverses course, but I still have a chance to make some big profits if the stock continues to go up.
Is there another Way to Manage the LEAPS Option Strategy?
There is another way to manage LEAPS options. This is something that I consider if I am still bullish on the stock and a price move up has not occurred by the time the LEAPS option reaches 352 DTE or the 1-year mark. This is when the time value starts to decline rapidly.
Remember the time value is the amount of time until the expiration date of the option contract. The longer the period until expiration, the higher the time value.
If we are at 352 DTE or 1 year, the extra cost to push the LEAPS option out and give yourself another year is usually very small. It typically costs .30 or so on a $10 option. In other words, $30 on $1000 LEAPS option contract.
So you will sell to close the current 1-year LEAPS option and BTO Buy To Open a new LEAPS option contract 1 year further out or around 2 years out. This is nothing in the scheme of things. It may increase in value the next month after you did this. However, the increase in value of the option will still be very high and will more than makeup for the small $30 investment to keep the LEAPS option on without being subject to the decaying time value.
Conclusion
LEAPS options are a great way to get involved in a stock without having to put up a lot of money. They also give you the chance to make some big profits if the stock price goes up. Just be sure to pick a deep-in-the-money strike price and go as far out in time as possible.
And be sure to have a plan for managing your trade.
Do you trade LEAPS options? What is your favorite strategy? Let me know in the comments below!
Happy trading!