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Long-Term Options: LEAPS, Longs and Dodging Volatility

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October 1, 2012
leaps long term options
Fredrik Broden

There's no arguing that options are time-sensitive instruments. They decay, which is one of the reasons many new traders shy away from them. And long-term investors—well, forget it. Most often, buying an option with a limited life span is like racing against the clock—the stock's gotta move before time runs out. And even that doesn't guarantee a profit.

So what do you need? More time. And that's what LEAPS options are all about. LEAPS—Long-Term Equity Anticipation Securities—are options that have expiration dates ranging from nine months to nearly three years. But these long-term contracts come with their own set of questions. How do they differ from standard options? And what strategies can a trader employ to take advantage of these differences?

Baby LEAPs

First and foremost, LEAPS are as close to buying a stock as you can get—without actually buying a stock. It's not an asset like a stock, but it does qualify as a security as the name suggests.

But even if you don't intend to hold them for the long term (many traders don't), LEAPS maybe useful in your portfolio, depending on your investing objectives. For example, you might want to have fair exposure to a certain sector, without tying up too much capital, or borrowing on margin. LEAPS can also run about 20% of the price of the underlying stock. So, if you only have a few thousand bucks to spare—a modest sum if many of the stocks you're looking at might be trading over, say $100—this might help you achieve some diversification and invest in options on a few different equities.

That said, you could implement a LEAPS-based strategy on individual stocks, or broad-based indices, or you could find a happy medium and build a sector-specific portfolio. And to boot, depending on the strategy you implement, if you hold a LEAPS option for at least 12 months, it could qualify for long-term tax treatment. But that's a question for your accountant, of course.

A Different Kind of Greek

To understand the differences between LEAPS and standard options, we have to delve into the world of option greeks. You may already be familiar with option greeks as they pertain to standard options. (See the glossary, page 42, if you need to brush up on greeks.). However, the option greeks that pertain to LEAPS options tend to have some significant differences. As a result, you may want to structure your LEAPS trades in considerably different fashion from your standard option trades. To illustrate, take a look at the following table:

at-the-money option contracts

For illustrative purposes only. 

The table compares two at-the-money option contracts. One option has a week left until expiration. The other has two years left. More specifically, XYZ stock is trading for $550 per share, and the table compares the one-week 550-strike call, with the two-year LEAPS 550-strike call. Even though the options share the same strike, the similarities stop there. Let's break down the difference between each greek.

DELTA
Notice that the delta of the LEAPS is significantly higher than that of the weekly option, even though both are at the money. You might expect delta to be about .50. However, in the real world, options are priced based on something called the “forward price of the stock.” Rather than pricing the options based on a stock price of $550, they are priced off $550, plus any interest on that amount, until option expiration. For the LEAPS call, the additional interest is enough, so that even though you are trading the 550-strike call, it's being priced off a value significantly higher than $550. Because the stock price being used is higher than the strike price, the option is technically in the money, and hence, it correctly reflects the higher delta.

GAMMA
The longer an option has until it expires, the smaller the gamma becomes. While the reasons can get complicated, think of it this way: gamma is a measure of how much the delta changes based on a small move in the stock. Since longer-term options are big-ticket items, a small move in the stock is likely to have a negligible effect, as compared to what it would do with a shorter-term option.

THETA
If gamma is fairly negligible in longer-term options, it follows that theta is also negligible. Why? Not only is theta the effect of time decay on the price of an option, but it's also referred to as “the price of gamma.” So, if you own LEAPS, you probably won't have to worry much about time decay until you start getting closer to its expiration day. That's what differentiates LEAPS from standard options, and is the reason they may be viable, alternative investment for certain traders to hold for months, even years, at a time.

VEGA
If there's one wet blanket to throw on the virtues of LEAPS, it's vega. The effect of volatility swings on an option's premium is a killer. In fact the farther out in time you go, the greater your vega. Take weekly options. The difference between a LEAPS option and an extremely short term option like a Weekly, is almost tenfold. In a nutshell, if the implied volatility level changes by so much as one percentage point, you could be looking at some fairly significant P&L swings. This is clearly something you need to address in order to successfully incorporate LEAPS into your trading arsenal.

RHO
Rho is typically the “forgotten” greek. In fact, you can get pretty far in an options education curriculum and never hear anyone mention rho. The reason is twofold. First, the change in the option value based on a one-percentage point change in interest rates is typically a small number. Second, interest rates don't commonly change by a full percentage point during the life of an option.

This all changes with LEAPS. Because of the lengthy period until expiration, changes in interest rates matter. Think of it like a bank loan. If you're going to borrow money for the next 30 days, then the difference between an interest rate of 4%, as compared to one of 5%, is fairly negligible. However, in terms of a 30-year mortgage, the difference in interest between a 4% rate, and a 5 % rate, is substantial. Well, that's a little primer on how rho gets factored into options.

Covered Call Revisited

Okay, so given what you now know about LEAPS, here's an example of how LEAPS could be used in a trading strategy, like selling covered calls, and how the greeks can impact your decisions.

By now, you've heard of the covered call—you know, where you buy a stock in increments of 100 shares, and sell a call against it that's slightly out of the money. While it's a common stock-trading strategy to help lower the cost of a stock, or provide cash flow from a stagnant stock, it can also benefit the LEAPS buyer in unique ways.

With a LEAPS “covered call,” Instead of purchasing stock, you could purchase an at-the-money LEAPS option and sell a slightly out-of-the-money, short-term call. Though the LEAPS option isn't an asset like a stock, you're “covered” because the strike of the LEAPS option is lower than the short-term option, and the expiration is farther out in time. Should you be Trading the LEAPS covered call this way has a twofold effect: were you to do this month after month, you could 1) offset the extrinsic value (time value) of the LEAPS option; and 2) you could reduce the overall positive vega of the position.

On the other hand, if the stock is at, or closer to, a recent high, it may revert and give back some of its gains. You could still lose the entire premium of the LEAPS, should this happen. However, remember that when the market falls, volatility typically rises. And a rise in overall volatility can have a large, positive impact on your large-vega trade.

And while we're currently in a world where interest rates have relatively little room to drop, a sudden spike in interest rates could provide an additional jolt to your LEAPS call option. So, who knows, you may find that rho could possibly become an unexpected friend.

LEAPS aren't a replacement for stock, but they can provide a few of the same benefits, without the erosive nature of short-term options. Don't get us wrong. They're still an option. So yes, you can just the same lose all your investment, as you can for short-term options. However, for traders with smaller accounts, who want to trade a few different securities without fear of rapid decay, LEAPS might make sense. Or, for traders who simply want exposure to sectors in which they're not comfortable tying up a lot of capital, LEAPS are a low-capital alternative. Heck, the CBOE recently listed five-year options on the SPX, known as “Super LEAPS.” That's an eternity to some traders. But, if you want longer-term exposure to the “broad market,” without tying up precious trading capital, or you want to try a longer-term trading strategy, like the covered call alternative, there's no shortage of ideas.

Speak Greek

Need to brush up on your options greeks? Go to the thinkorswim Learning Center and type in "greeks" in the search box. You'll be glad you did.