How and when to use LEAPS stock options

Key Points

• LEAPS are long-dated options contracts with expirations at least 12 months out.
• You can use them with options strategies where the investor can collect heavy theta premiums.
• Speculators can bet on recovery from a sharp price drop on a short-term temporary catalyst like an inventory glut, migration to a subscription model, or backlogged orders with raised full-year guidance.

Suppose you're a long-term investor looking to collect premiums passively or strongly believe in a stock's long-term price move. In that case, Long-term Equity AnticiPation Securities (LEAPS) options may be for you. LEAPS option contracts are not always available in any stock in any stock sector. If you are familiar with stock options trading, you can apply the same strategies with LEAPS. LEAPS are very long-dated options that have expirations at least a year out.

Filtering the noise

While short-term price moves may have too much noise, most investors firmly believe in the long-term direction of stocks. Day traders attempt to capitalize on short-term price fluctuations, but investors want to capitalize on larger swings spread out over a longer period. This is where LEAPS comes into play for investors.

Maximizing percentage gains with leverage

Let's take an example of using the social media platform Snap Inc. NYSE: SNAP, which is trading at $16.20. If you spent $900 on SNAP, you would have 55 shares of stock. The SNAP LEAPS call option with a $20 strike price expiring 12 months from now costs $3. 

You can buy three contracts for $900. If SNAP rises to $25, then the XYZ shares would gain $8.80 per share on 62 shares for $484 for a 54% profit. However, the LEAPS option would be worth $5 per contract on three contracts for a profit of $1,500 on a $900 investment for a 160% return on investment. You would receive over three times the return for the same principal amount.

On the flip side, if SNAP stayed flat at $16.20 after 12 months, your 55-share investment in SNAP would still be worth $900, however, if you bought the LEAPS. They would expire worthless, leaving you with a $900 loss. The stock would have to rally 41% to break even on the LEAPS, meaning it would have rallied to $22.90 from $16.20. That's a large underlying price move required to break even on the trade. However, why not put the odds in your favor? 

Collecting big rent premiums

In an earlier article, we reviewed how to collect rent on your stock holdings by writing covered calls. You can supersize your rent premiums with LEAP options. In the same example with SNAP, you can purchase the stock and sell the LEAP-covered call rather than buy a directional LEAPS call option. This is assuming you have the capital. If you purchased 100 shares of SNAP at $16.20, it would cost you $1,620. If you sold the $20 LEAPS call option for $2.90, that would give you a $2.90 premium.

If XYZ were to rise 41.6% to $22.94, you would also reap the profit of $3.80 after being called out at the $20 strike price. This would result in a total profit of $2.90 premium and $3.80 price appreciation for $6.70 or $670 for a 41% return. It may not be as much of a return as buying the shares and holding or buying the calls, but there is also downside protection of the $2.90 premium. If XYZ remained at $16.20 after 12 months, you'd still gain 18% just for the premium. If SNAP fell in price, you'd be hedged to $13.30 to break even.

In the covered call scenario, you would either gain a maximum profit of $41.60 or an 18% minimum profit if SNAP remains flat. 

In the stock purchase scenario, you would gain 55% on a move to $25.00 or 0% if SNAP remains flat.

In the long LEAPS call scenario, you would gain 150% on a move to $25.00 or lose 100% if SNAP doesn't rise 41.6% to at least $22.90. 

Applying multiple strategies with LEAPS

LEAPS are just options with much longer expiration dates. You can use most options strategies with LEAPS. 

However, it's crucial to understand that premiums are vastly elevated mostly due to theta (time erosion). If you're playing directional trades, you will pay a large premium for time decay. It pays to be aware of the options Geeks before stepping into LEAPS. Straddles can be played, but you must take the premiums into account. As a rule of thumb, don't expect stocks to rally more than the benchmark indexes. In those cases, collecting premiums and writing covered calls may be more beneficial, selling puts or debit spreads.

Speculative scenarios for directional LEAPS

You can use LEAPS for speculation in certain scenarios for risk-tolerant investors if a stock collapses on its earnings report over a temporary catalyst like an inventory glut or backlog over migrating to a subscription model. When a company lowers near-term guidance but raises annual guidance, it may indicate large orders pushed to later quarters rather than demand shock. 

This implies a temporary hiccup in its business and could be played for a longer-term recovery. Identifying chart patterns on wider time frames, like the weekly and monthly candlestick charts versus intraday time frames is also beneficial.