When most people think about investing, they think about buying stocks. While this is a sound investment strategy, there are other options available to you that can be just as profitable that use less capital and have fewer risks. LEAPS stock options do exactly that! In this article, we will take a look at what LEAPS options are and why you should consider using them instead of buying stocks!
We will answer the questions:
- What are LEAPS stock options?
- Why should you buy LEAPS options instead of stock?
- What are the benefits of LEAPS options?
- What types of stocks are best for LEAPS option trades?
- What is the optimal way to put on a LEAPS option trade?
- How should you manage LEAPS option trades?
- What are the risks with LEAPS options?
- Conclusion
What are LEAPS stock options?
LEAPS are long-term equity anticipation securities. They are options with expiration dates that are much longer than the standard options contract. The LEAPS acronym stands for Long-Term Equity Anticipation Securities.
LEAPS options are a way to buy the option to buy a stock at a later date. LEAPS options have an expiration date that is much longer than the standard options contract.
Why should you buy LEAPS options instead of stock?
There are a few reasons why you might want to consider buying LEAPS options instead of stock.
The first reason to buy LEAPS options over stock is that LEAPS options give you the ability to control a large number of shares with much less capital. This is because when you buy a LEAPS option you are only paying for the right to buy the stock, not the actual shares themselves.
Another reason to consider buying LEAPS options is that they offer limited downside risk.
This is because the most you can lose on a LEAPS option is the premium you paid for it.
You may pay $500 for a LEAPS option contract on stock ABC which is trading at $20. If that stock ends up going to zero the most you are out is the $500 that you bought the LEAPS option contract for. If you owned the stock instead, it would have cost you $2000. So you would have lost 4 times as much money if the stock tanked and went to zero.
What are the benefits of LEAPS options?
There are several benefits of LEAPS options. As we mentioned, one benefit is that they can be purchased at a fraction of the price of the underlying stock. This means that you can get exposure to a stock for less capital outlay.
Another benefit of LEAPS options is that they provide you with more time to see your trade play out in comparison to shorter-term option contracts. This can allow you to hold onto a position in a stock that you believe has long-term potential but is currently undervalued.
As previously mentioned, LEAPS are also defined risk trades so the max loss is limited and known when you put the trade on.
Lastly, LEAPS options can be easily managed and rolled out in time if they are not profitable right away.
What types of stocks are best for LEAPS option trades?
There are a few factors to consider when choosing stock for a LEAPS option trade.
The first factor is the price of the underlying stock. You want to choose a stock that is trading at a price that you are comfortable with and think will increase in price. I like to use LEAPS options during a market correction or bear market when all stocks across the board have been hit.
This is the time when you can pick the best-in-class stocks in sectors that have been hit but are expected to rebound in the future.
Another factor is the liquidity of the underlying stock. You want to choose a stock that is traded on a major exchange and has a high daily volume. This will help ensure that you will be able to exit your position if you need to.
Lastly, I look for stocks that are not too high-priced. This makes the cost to control 100 shares much less. So I will go for a stock like F Ford at $11 versus a stock like Costco (COST) at $490.
What is the optimal way to put on a LEAPS option trade?
There are a few steps to putting on a LEAPS option trade. The first step is to choose the stock that you want to trade. As we mentioned above, you want to choose a stock that is trading at a price that you are comfortable with and think will increase in price.
The second step is to choose the expiration date of the options contract. You want to choose an expiration date that gives you enough time to see your trade play out. I like to go out for 1 year or more. Often, you can go out for 2 years and not pay much more in premium than just 1 year.
The third step is to choose the strike price of the options contract. The strike price is the price at which you will buy or sell the underlying stock if you exercise your option. I recommend going deep in the money.
There are a couple of reasons for going deep in the money. First, it will reduce the time premium that you are paying. Time premium is the amount that you pay for the options contract over and above the intrinsic value. What this means is that you are getting a deal! I’ll show you in the upcoming example.
The second reason is the delta is closer to 1 when you go deeper into the money. Delta is the amount that the option price will move for every $ move in the underlying stock. So if the stock moves up $20.0, and the delta is 0.95, then the option will move to $19.0 (0.95*$20).
What this means is the trade moved $190 to the upside! You can then look at the amount invested upfront and calculate the ROI. If you paid 1.90 or $190 for that LEAPS then you just made a 100% ROI or Return On Investment.
How should you manage LEAPS option trades?
There are a few things to keep in mind when managing LEAPS options. The first is that you should never invest more capital than you can afford to lose.
The second is that you should always have an exit strategy planned before you enter into a trade. This will help you avoid being caught in a losing position if the stock price moves against your expectations.
When a stock moves against me I take another look at the fundamentals, technicals, last conference call, and news to see why it is down. When something changed since I put on the trade and I no longer like it, I will sell to close and get out. If nothing changed and I still believe in the stock then I will stay in and hold.
If I am holding, time passes and I am down to 1 year out DTE, then I will look to sell to close. I will then buy to open again further out closer to 2 years and go deep in the money again. You can often do this almost for free or by paying very little since the option we are selling to close is still 1 year out.
Time decay is our enemy in this case since we are buying the option. So if we stay outside of 1 year we are closer to replicating owning the stock and time decay does not come into play as much.
What are the risks with LEAPS options?
There are a few risks with LEAPS options. The most critical risk is that the stock can go down in price. If this happens you will lose money. The good news is that you will only lose the amount you paid for the option. You will likely lose less money than if you owned the stock outright.
Another risk is that time decay can eat away at your position if the stock does not move in the direction you expect it to. However as mentioned above, we recommend placing trades 2 years out and managing at 1 year. This almost eliminates this risk.
Conclusion
LEAPS options can be a great way to trade stocks that you believe have long-term potential. They offer the same upside as buying the underlying stock, but with less capital required and less risk.
Remember to always manage your risk and have an exit strategy planned before entering into any trade. LEAPS options can be a great tool for long-term investors and traders alike.
Do you have any experience trading LEAPS options? Let us know in the comments below!
Happy trading!