LEAPS: The Magic Trick for Turning Small Stacks into Big Stacks

Long-term Equity AnticiPation Securities, or LEAPS, are the antithesis of most options plays. People generally think of options as short-term plays. LEAPS, however, offer a long-term options solution. LEAPS are call options that do not expire for many months, usually more than a year. Often, certain stocks offer LEAPS that don't expire for 2+ years. These call contracts are very versatile and offer many advantages.

This post will explore LEAPS and describe some of their uses. If you do not know how to use LEAPS, you are missing an important tool from your options playbook. Keep in mind that LEAPS is both the singular and plural form of the word.

Elements of LEAPS

Time: LEAPS are call contracts that have “many” months to expiration. However, there is no set rule across brokerages or within tax law regarding what qualifies as a LEAPS. For strategies that use LEAPS, we typically need a call that expires at least 9 months out, though some LEAPS will have 3 years before expiration.

Moneyness: The adjective for describing something’s status as being in-the-money, at-the-money, or out-of-the-money is called a contract’s “moneyness.” LEAPS are not necessarily ITM by definition. However, ITM LEAPS enable several strategies like the Poor Man’s Covered Call and Stock Replacement, both of which are suitable for small accounts.

Delta: Closely related to moneyness is delta. Delta is the Greek that tracks how much a contract’s price will change for each dollar of change in the underlying stock. For example, a call with a delta of 0.800 will change in value by $0.80 for every dollar of change in the stock’s price. Essentially, this is like holding 80 shares. LEAPS with a high delta enable the trader to get significant exposure to the underlying stock without having to shell out for a large number of shares.

Premium: LEAPS are an expensive kind of contract because they have a long time before expiration and therefore a significant amount of extrinsic value, and because they are often ITM with a high delta. A 12/16/2022 SPY $250 LEAPS, for example, will cost the trader almost $9,000. However, traders can also purchase OTM LEAPS on stocks they feel strongly about for a lower price, thus controlling a very high delta on their relatively cheap investment.

Type: LEAPS can be calls or puts, but traders more commonly buy them as calls. Certain strategies can benefit from selling ITM Put LEAPS, while buying Put LEAPS can be an effective but expensive hedge.

Uses of LEAPS

This section will discuss how traders can use LEAPS and what methods I prefer.

Leveraging yourself to your personal risk tolerance: LEAPS offer the investor an opportunity to leverage himself into any optionable stock. If a trader wants to take a large position in PRU with the belief that the stock will rise gradually for the next 2 years, then buying shares would be a good way to profit. With a $5,000 portfolio, the investor could buy about 80 shares as of July 20, 2020. Alternatively, the investor could instead buy 5x 1/21/2022 $60 LEAPS for $1,200 each. These LEAPS have a delta of 0.675, so owning 5 LEAPS is the equivalent of owning about 337 shares. With a smaller portfolio, the trader has effectively more than quadrupled his exposure to PRU.

Stock Replacement: Similar to the above, the investor can use LEAPS to take positions in contracts that are similar to owning shares, but at a lower cost. If the investor could find a LEAPS with a delta of 1.000, then the call would follow the underlying stock to the penny. However, LEAPS tend to cap out between 0.900 and 0.950. Buying a 0.950 delta is usually close enough to owning shares to satisfy the investor. So rather than spend $5,600 to own 100 shares of AMD, the investor can buy a 1/22/2022 $40 LEAPS for $2,100. That contract has a delta of 0.900, so for $2,100, the trader has effectively purchased 90 shares. This leaves the $5,000 account investor with $2,900 for other plays. Using LEAPS can help diversify one’s portfolio by spreading a smaller amount of capital across many positions.

Stock Replacement with Leverage: Big brain time. You can sell deep ITM puts with deltas above 0.900 to take a position virtually identical to if you had bought 90 shares. But in the case of selling puts, you don’t have to spend any money. In fact, you get paid a nice premium for selling ITM put LEAPS, and depending on your broker, you might only need to hold 10% of the collateral in cash. In theory, you could sell a handful of 0.900 delta put LEAPS for a hefty premium, which you can then turn around and use to buy call LEAPS. If you are correct and the stock takes a boat to the moon, you will benefit doubly. The short put LEAPS will lose value causing a gain, and the long call LEAPS will increase in value. Be careful, because you can wreck yourself if you’re wrong about the underlying.

Speculation: LEAPS do not have to be ITM. If you thought back in April 2020 that TSLA would fly to $1,000 by sometime before September 2022, you could have bought the 9/216/2022 $1,000 call strike for about $500 at the time. Today, that contract is worth over $83,000. A $6,000 investment into TSLA LEAPS would be worth about $1,000,000 today. And unlike an FD, you don’t have to time the purchase perfectly; you’ve got a few years.

Poor Man’s Covered Calls: Poor Man’s Covered Calls (PMCCs) use LEAPS as collateral to write covered calls instead of blocks of 100 shares. It is not my preferred method of trading covered calls (I prefer the wheel), but PMCCs can be very effective in smaller accounts. I wrote another post on PMCCs here.

My Preferred Methods

I am more conservative than most options traders, which is why I joined Theta Gang. Therefore, I am not going to be the type who uses LEAPS to maximize leverage. However, I am a big fan of using LEAPS as a stock replacement strategy, and I use PMCCs in my Robinhood $3k Challenge account.

Why I prefer stock replacement: I believe a strong portfolio needs a foundation of reliable stocks. Unfortunately, investors can get priced out of strong companies and are therefore tempted to buy loads of garbage stocks specifically because they are cheap. Cheap, garbage stocks are not a strong foundation for your portfolio. Instead, investors can use LEAPS to get the equivalent of 80-90 shares of a reliable company for a lower price than buying their junk shares. Further, large investors can utilize LEAPS to further diversify their portfolios by taking sizable positions in a wider variety of companies on the cheap.

Why I am iffy on PMCCs: In a traditional covered call, you cannot lose money if the underlying gets too high. You just miss out on higher gains. In PMCCs, you can actually lose money if the stock rises too quickly. Strong companies are the best ones to take long positions in, and are also the most likely to leap higher on short notice. I dislike the prospect of getting burned by a rising underlying, and so will always prefer traditional covered calls over PMCCs. PMCCs carry additional risk. However, small accounts that cannot or do not want to buy 100 shares of stock to sell covered calls can still benefit from PMCCs as long as they control their risk.

My current LEAPS plays

I own 3x 12/16/2022 SPY $250 LEAPS. I bought them for about $6,700 each; they are now worth almost $8,900 and their delta is about 0.850. Effectively, I own the equivalent of 255 shares of SPY on an investment of $19,500 instead of the $75,000 the shares would have cost at the time of purchase. I will likely roll the LEAPS for a hefty profit in the fall of 2022.

I am selling calls against 1x of the SPY LEAPS to create a PMCC. With SPY continuing to rise, I am continuously getting burned by gamma and forced to roll. I am still overall delta-positive on the PMCC, so I am not losing money as SPY rises. I do, however, run the risk of becoming delta-negative if SPY keeps rising over many more months. Once I can get out of this short call, I intend to just hold the 3x LEAPS naked.

Drawbacks of LEAPS

1) No dividend: LEAPS holders do not collect dividend, so holding actual shares is still the more advantageous position if dividend is important to you.

2) Expiration: LEAPS will eventually expire. Although a good LEAPS will likely sell for a hefty sum on expiration, you will need to either put up the cash to execute or roll to keep the LEAPS open. Fortunately, ITM LEAPS tend to carry little extrinsic value, so you can recover most of your initial investment even if the stock has not risen by expiration.

3) Wide bid-ask spreads: LEAPS trade relatively thinly and can have wide bid-ask spreads. Use limit orders to get a decent price, or you are liable to buy a LEAPS for significantly more than the bid.

4) Low volume: Sometimes, LEAPS contracts only change hands a few times per day. I have even found 0 daily volume on my SPY $250 LEAPS on occasion. Therefore, the prices during the trading day may not update to reflect changes in the underlying’s price. However, each morning all contract prices adjust to reflect accurate values based on the Greeks. The takeaway here is that LEAPS are investment vehicles, not trading vehicles.

Summary

LEAPS are an important part of your toolbox. Small traders can use LEAPS to build a strong foundation for their portfolio at a lower cost than holding shares. Meanwhile, large traders can use LEAPS to expand their portfolios and take larger positions than they could otherwise afford. Speculators, perhaps the most rowdy of the bunch, can buy OTM LEAPS in anticipation of big price moves with a greater time buffer than FDs. And if they’re really aggressive, can even sell ITM put LEAPS to buy OTM call LEAPS and thus multiply their delta exposure significantly.

Disclaimer 

I have written my thoughts on LEAPS based on my experience and understanding. However, I am not a financial advisor. Be sure to perform your own risk management and due diligence before making any investment. Consult a licensed financial advisor when you require professional assistance.