Have you heard about LEAPS options trading strategies and wonder what they are, and how they work? Or maybe you found this after reading an article, watching a video about leaps options, or trading in general and wanted something more - maybe something that made more sense to you.
In this article, I’m going to go over 2 leaps options trading strategies: buying deep in the money leaps calls, and selling deep out of the money leaps puts. And I’m going to do my best to explain it in a way that’s as easy as possible. In a way that even my grandmother could understand. Well, that’s the plan.
I’m also going to show you how to scan for leaps options opportunities using a powerful options scanning tool you’ve probably never heard of.
What are leaps options?
LEAPS options stand for Long Term Equity AnticiPation Securities. And what makes a leaps option an option? A leaps option is a call or a put option with an expiration date far in the future. Some say a minimum of 9 months and more, others say more than 1 year. Either way, leaps options expire far in the future. And some leaps options expire as far as 3 years out. However, trading strategies for leaps options vary considerably when we’re talking about an expiration date so far in the future. For example, with the SPY (the S&P 500 Index ETF), there are leaps options that expire more than 3 years out.
Now, you might be wondering, why would I want to buy, or sell a leaps option, so far in the future? Why not sell one that expires this week or next month? The further out you buy a call, or sell a put, the higher the chance you’ll profit. And the key to a profitable leaps trading options strategy is to tilt the chances in your favor.
SPY - An Investors Favorite
Now for the purposes of this article, I’ll refer to the SPY - or the S&P 500 ETF. But, there’s nothing stopping investors like you, from considering other companies, like Apple, Google, Tesla, or any other quality company that you’d like to own. And also, I’ll assume you’re looking to take a bullish stance on your investing strategy. In other words, you expect the underlying stock or equity to go up. If you think stocks are going down, stop reading right now, as it’s not for you.
Now, investors can buy and sell leaps options on virtually any stock, ETF, commodity, or even index. And, the best investors will say, if you’re going to buy or sell options, do so on only the best stocks. The ones you’d be happy to own. Not on something you heard of in a Reddit group, or some strange yolo feed that talks about stonks and tendies. Not that it’s all bad… it’s just far too risky - like the casino. And for me, when it comes to investing, I’d rather have the odds in my favor. And, the right leaps options offer me the best chances to profit.
Types of LEAPS options and strategies
There are two types of options: call options and put options. Investors can buy and sell calls and puts, and they do, daily. Call options give the buyer the right, but not the obligation, to buy 100 shares of the underlying security, times the number of contracts, at a set price, at any time up until expiration.
Buying Leaps Call Options
For example, let’s consider the SPY ETF. It’s probably the most common ETF that tracks the S&P 500. If, as part of an investor’s leaps options trading strategy, they bought one SPY call with a $400 strike price that expires on December 9, they could exercise the option at any time up until December 9 and buy 100 shares of SPY for $400 a piece. The nice thing about it is that exercising is optional. Because, In this trade, the investor would have $50 of intrinsic value, and if there’s still time before expiration, they could just sell the option, and make even more.
Selling Leaps Naked Put Options
Now, you might also be wondering about selling leaps put options. Selling out of the money put options is another bullish strategy, and it’s an amazing way for investors to generate income because the risk is essentially the same as owning a stock. Put options offer buyers the right, but not the obligation to sell 100 shares of the underlying stock, times the number of contracts, at any point until expiration to the contract holder, or you the put seller. In other words, the person holding the put option could make the seller buy 100 shares of the underlying stock or equity, times the number of contracts, at the strike price, at any time before expiration.
Leaps Naked Put Option Example
Taking the same example from before, let’s say an investor sold an out-of-the-money SPY leaps put option with a $300 strike, with a December 9 expiration. And for that, they collected $21 in option premium. And on expiration, SPY is trading below the strike at $290, well, the investor can expect to be put 100 of SPY for $300 a piece, even though they are only worth $290. In this case, the P&L would look like this: $21-$300+$290=$11 profit. And to get the total, multiply $11 by 100 shares to get a final profit amount of $1100. Not bad. Now, if the underlying security moves further below the strike, and it becomes “in the money”, well, the investor can always roll the option to a lower strike, and further out. Traders roll options by issuing a “buy to close” close order on their put option, and then sell another with a lower strike price. The premium collected from the new option may cover, or at least partially cover the cost of purchasing the option back from the market.
Why Do Investors Buy Leaps Put Options
Now, you might wonder why people buy leaps put options. The reason traders buy leaps put options is to protect themselves against potential losses. But, since stock markets usually go up, you can use this to your advantage. In fact, traders will make the most money with this leaps strategy if they sell put options when volatility is high, as it was back in March and April of 2020.
Benefits of Buying Leaps Call Options
When it comes to leaps call options, investors typically gravitate toward deep in the money Leaps call options. This way, they get the ability to control 100 shares of the underlying security, per contract, for a lot less money than owning the underlying stocks, or equity outright. What boggles my mind is that in many cases, deep in the money leaps call options, like those with an 80 or 90 delta will cost about half as much, or less, than owning the stock outright- with very little extrinsic cost.
One thing that’s amazing about this strategy - buying deep in the money leaps call options is that the investors’ downside is limited to what they paid for the option. In other words, you can’t lose more than what you paid for the option.
Buying A Leaps Call Option on SPY
For example, Alex, the investor, buys 100 shares of SPY for $400 a piece, that’s a $40,000 outlay. And, let’s take Logan, another investor, who decides to buy a deep-in-the-money LEAPS call option on the same SPY with a $200 strike and an expiration date 3 years out. The premium for that is $210. In this example, Logan gets to control 100 shares of the SPY for $21,000.
Now, in this case, because Logan bought a $200 strike, he gets some downside protection because, if the SPY goes below $200 at expiration (which is unlikely in today's market, but if it does), his loss is limited to what he paid for the option $21,000.
But Alex, on the other hand, his loss doesn’t necessarily end there. If the SPY went below $200, well, Alex would stand to lose more! For example, if the SPY went to $150, Logan’s losses would be $25,000. And if it went down to $100, the loss would be $30,000.
So, by buying a leaps call option, Logan gets to participate in ALL the upside of the SPY over and above the $200 strike price, - just like Alex. Only, Logan also gets downside protection below $200. And for that, it costs just a little bit of extra premium. Alex on the other hand, got 100 shares and paid full price. Who’d you rather be? Alex or Logan? Let me know in the comments below, and why. I love reading and responding to comments!
Benefits of Selling Leaps Put Options
When it comes to leaps put options, many investors sell deep out of the money leaps put options. It’s also known as a naked put, or a cash-secured put. Either way, it’s a bullish bet with no more risk than owning a stock. What’s amazing about this strategy is that investors can sell deep out of the money put options, with 70% or 80% chance of expiring worthless. And, they get to collect some hefty income along the way.
SPY Leaps Put Option Example
For example, let’s take SPY again, and assume it’s trading for $400 a share. Say Alex, the investor, sells one naked SPY leaps put option with a $300 strike that expires in 3 years. And he collects $14 for the option, or $1400 for the contract. That’s income Alex gets to keep.
Now, in this case, because Alex sold the $300 strike, he’s in good shape as long as the SPY stays above $300. And if the SPY is above the strike at expiration, Alex gets to keep the $14. Now, if the SPY goes below $300 by expiration, one of two things can happen. If Alex does nothing, he’ll be forced to buy 100 shares of the SPY at $300 a piece, times the number of put options contracts sold. Or, Alex can roll his option to a future expiry, and recover some or all of his losses.
How to Roll a Leaps Put Option
If Alex finds himself in a situation where the SPY is below the leaps put option strike price of $300, he can roll the leaps put option. To do this, Alex will first close out his options contract, by buying back the option he sold, in this case, the $300 SPY with the same expiration date. Alex will have to pay more for the option than he originally received. Let’s say, for example, the put option now costs $30. This means Alex’s loss is now $16. However, Alex can now sell another put option, further out, and make up the difference. As a best practice, investors often find it best to wait out volatility. And, with a leaps put option, that could mean waiting years before closing or rolling the trade.
Best Stocks and ETFs to Trade Leaps Options On
It’s natural to wonder what stocks should be part of your leaps options trading strategy. For bullish leaps options trading strategies, such as buying leaps calls or selling cash-secured leaps puts, the key is to buy and sell options only on quality stocks and ETFs. Investors who buy leaps call options on poorly chosen companies could end up losing all their money if the company goes to zero. And similarly, investors who sell leaps put options could end up underwater if the stock or ETF fell far below put option the strike. Remember, buying leaps calls and selling leaps puts are bullish strategies, so we as traders want the underlying securities to go up! So what are the best underlying equities to invest in?
Simply the Best
Well, I like to start with the dividend aristocrats and dividend kings. These are companies who have not only paid a dividend for, well in many cases well before I was born, but, they’ve also increased their dividends consistently, every year for decades. These are companies like McDonalds who have more than 39,000 locations in more than 100 countries. Or Proctor and Gamble who sells Gillette, Tide, Charmin, Crest, Pampers, Febreze, Head & Shoulders, Bounty, Oral-B, and many more. When I’m researching these companies, I like to first check suredividend.com. This is a site I use daily where I can read the latest updates on dividend stocks. And the sure dividend newsletter, which is their flagship product, sends me monthly buy / sell updates from their 700 dividend stocks they track.
Aside from dividend stocks, you can also buy leaps call options, and sell leaps put options on index ETFs like the SPY. And since it’s an ETF that tracks the S&P 500 index, it actually holds the same 500 stocks on the index. So, there’s always tons of liquidity available.
But, knowing the companies I like to buy call options, or sell put options on is just half the battle. For this, I use Options Samurai.
Investors love to use lingo, such as, in the money, and out of the money. But, what does it mean? Regardless of the leaps options strategies investors invest in, they’ll need to know the difference between “in the money”, “at the money”, and “out of the money”. Knowing the difference between these three will help you make better decisions when buying and selling options.
In The Money
Let’s start with “in the money” options. An in-the-money option means that the option has intrinsic value. It’s actually worth something. Intrinsic value is the difference between the underlying equity, and the strike price. For call options, “in the money means” that the underlying equity trades above the call option strike price. For example, let's take the SPY, and let's say it trades at $400. With a call option, any strike under $400 is in the money. Put options are the opposite, so if XYZ trades below the strike price, then it’s in the money.
At The Money
Next, we have “at the money options” - and these have little to no intrinsic value. For both call and put options, “at the money” options have a strike price around the underlying security price. Again, taking from SPY, an at the money strike would be around $400, because the ETF trades at $400.
Out Of The Money
“Out of the money” means there is no intrinsic value. For call options, “Out of the Money” means the underlying equity trades below the strike price. And for put options, “Out of the Money” means the underlying equity trades above the strike price. And when an option expires out of the money, it expires worthless, which is perfect for options sellers, because they get to keep all the income!
After some time, investors may have noticed that their leaps call options might be worth significantly more than they paid for it. It’s not unheard of to have the option worth double or triple what you paid before expiration.
And similarly, for put options, it’s not unheard of that the option price plummets, and presents the investor with an opportunity to buy it back for pennies on the dollar. But, what about liquidity?
In either of those cases, if the call option is far in the money or the put option is far out of the money, the trader will be in a profit position. However, if liquidity is thin, it might be difficult to close the trade. For example, it’s possible that no one is buying the call option the trader wants to sell. Or, no one is selling the put option the trader wants to buy to close out the trade. But, there’s always a way.
How to Close a Trade When There is Little to No Liquidity
Remember, with a call options contract, only the buyer can exercise their rights. So, if you’re a leaps call option holder, you can exercise your rights, and call the options. To exercise a call option, the trader will notify their brokerage, or they may even be able to do it in their online trading account.
When the trader exercises an “in the money” call option, they buy 100 of the underlying equity, times the number of contracts, for the strike price - which could be significantly lower than the current trading price. The trader will get the stock or underlying security at a huge discount. And then, the trader can sell the shares or underlying equity back to the market, for a profit. The profit will be the difference between what the trader paid (the strike price) and the current trading price.
Exercising a Leaps Call Option Example
Let's say you bought a leaps call option on the SPY with a $300 strike price, and today, the SPY is trading for $400. Well, you can exercise your right as a call option holder to buy 100 shares of the SPY for $300 a piece, and then sell them back to the market, at the market price (which at this moment, could be $400 a piece.) And the difference is your profit.
Now, if a trader sold a leaps put option, this is a bit different. They’ve already collected the option premium, that’s the income they earned from selling the put option. And their goal is for it to expire worthless. But, if the trader wants to close out the trade, they’ll need to buy the same put option from the market. To do this, the trader will check the latest bid/ask prices, and be careful to set a limit order to buy back these put options. Setting a limit order limits the price you’ll pay. Because, if you set a market order, well, you could end up paying a lot more for the option than needed. For that reason, it’s always best to set a limit on the amount that you’re happy with.
Intrinsic vs Extrinsic Value
Next we need to consider intrinsic vs extrinsic value. Intrinsic value is the difference between the current stock price, and the strike price, or how much “in the money” the leaps option is.
Let's consider the SPY, and say it’s trading for $400. If a trader holds a leaps call option with a $300 strike price, then there’s $100 in intrinsic value. And if the strike is $210, then there’s $190 of intrinsic value.
But that’s not all. We also have extrinsic value. And calculating extrinsic value is incredibly important so that the investor knows how much premium they’re paying to invest in their leaps options trading strategy. We as traders want to pay as little extrinsic value as possible. Traders can calculate extrinsic value like this:
We take the underlying security value, say the SPY at $400
Consider the leaps call option strike price, let’s say $210
But to calculate the extrinsic value, we have to consider the cost of the option. So, let’s consider the leaps call option current value, or the asking price, today it’s $200
Extrinsic value is the underlying security, minus the strike, minus the call option’s current value, also known as the premium.
So in this case, the extrinsic value is just $10. Just ten dollars! The extrinsic value is the extra you, the investor pay, to control 100 shares of an underlying security. And in many cases, investors can find 100 delta leaps call options, with $0 of extrinsic cost. In other words, they can control 100 shares of an underlying security, for far less than buying the underlying equity outright!
Investors calculate returns based on the crystallized amount they receive from their leaps option, divided by what they originally paid.
Taking from the above example, let’s consider Alex and Logan once again. And we’ll make up some round numbers to keep it simple.
Remember, Alex bought 100 shares of the SPY for $400 a piece, for a total of $40,000 and Logan decided to engage in a leaps option strategy and bought a call option with $200 strike price, deep in the money - expiring 3 years into the future. And he paid $210 for it. This strike also has a 90 delta, which is represented as .9 on your trading platform, meaning for every dollar the SPY goes up, the call option will go up 90 cents.
Fast forward 30 days, and let’s say the SPY had a good month and went up 4%. It’s now trading for $416. The call option, with it’s 90 delta means it’ll go up $14.40. Here’s how we calculate it. We take the delta (.9) and multiply that by the $16 the SPY went up. And, we get $14.40. Then we add it to the original cost of the option which was $210. That means the option will theoretically be worth $224.40. Now, one thing we didn’t note was theta. For deep in the money leaps call options, theta will be minimal. And I’ll cover that in the next section.
Alex’s return is $41600 / $40000 or 4%
Logan’s return, however, is $22440 / $21000 or 6.9% for the period.
Putting it differently, Logan got a 72.5% HIGHER return than Alex!
And if we look at it on an annualized return, Logan would have more than 116% annual return in just one month. That’s the power of leaps.
The Greeks in Options Trading
Okay, so far in the video I’d mentioned Delta a few times, and once or twice I may have added theta. When putting together a leaps options strategy, it’s important to know the greeks, because, one, most people don’t, and because of it, it’ll give you an edge over the rest.
Delta tells us how much the option price will go up, or down, based on every $1 change in the underlying security. Delta is usually measured as a decimal, like .35 or .8 or .9. And if you’re looking at a leaps call, for example, one that has an 80 delta - remember, it’ll be expressed as .8, then it means for every dollar the underlying security goes up, the option will increase in value by 80 cents. And yes, if the underlying goes down $1, the underlying security goes down 80 cents.
Delta also tells us, approximately, the chances it will expire with or without value. So a leaps option with an 80 delta means there’s about an 80% percent chance it will expire in the money, or with some value. Putting it differently, an 80 delta means there’s about a 20% chance it will expire worthless. And a 90 delta means there’s about a 10% chance it will expire worthless.
Theta tells us how much the option will lose in value, every day, assuming the underlying security doesn’t change in price. Theta is expressed as a negative number, since it’s the amount the option will lose in value each day. So, say you have a theta of -0.10, that means the call option will go down in price -- 10 cents a day, if the underlying security doesn’t change - but it will. So, delta and theta go hand in hand. And as a result, options with a shorter expiry will have a higher theta value than leaps options that expire further out.
Vega measures an option’s sensitivity to implied volatility. Vega tells us the change in the option’s price for a one-point change in implied volatility. And options are more expensive when volatility is high. Just like when volatility is low, options prices go down.
Let’s say a trader is considering a leaps call option strategy. The trader wants to buy a leaps call and the option costs $100, its implied volatility is 20, and it has a vega of .12. And then, implied volatility goes up from 20 to 22 - a 2.0 volatility increase. To calculate vega, multiply vega by the difference in volatility, and that’s the amount you add that amount to the call option price.
In this case, the option price will increase 24 cents to $100.24 because .12 * 2 is 24 cents. And as you may have guessed, with leaps options, because they expire so far into the future, volatility affects them FAR more than options that have a nearer expiry.
Next, we have Gamma. Gamma tells us the rate of change between an option's Delta and the underlying security’s price. Higher Gamma tells us that the Delta could change a lot, even with minimal price changes in the underlying security. So if you’re buying a call, higher gamma means the price of the call option will increase, if the underlying security goes up.
Now, if your leaps options trading strategy is to buy deep in the money leaps call options, gamma isn’t all that important, because it will be a low number. Gamma is important for “at the money” call options, because with an at the money option, if the stock moves just a little and the option is out of the money, then it loses all its intrinsic value.
Rho tells us the leaps call option sensitivity against changes in the risk-free interest rate - that’s the interest rate paid on Treasury bills. Rho is expressed as the amount of money an option will lose or gain with a 1% change in interest rates.
Now, because Leaps options have a long expiration date, traders will want to consider Interest rate risk. Rho helps answer the question of whether the interest rate paid on a savings account is better than investing it in the option. So yes, traders who buy LEAPs options need to know this.
Final Thoughts on Leaps Options Strategies
I hope this article gave you a little more insight into leaps options strategies. Let me know in the comments below if you trade leaps options, or if you have any questions about them. I’d love to answer them!
This article originally appeared on The Financially Independent Millennial and was republished with permission.