MARKET INSIGHT: Using LEAPS to Profit in the Markets
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June 10, 2004
Long Term Equity Anticipation Securities, or LEAPS, have been around for a long time but too often go underutilized as a tool for option strategists to build their account. There are several ways a strategist can employ LEAPS in the stock market and in this market insight piece we will not only discuss what these instruments are but also the various applications a trader should consider.
LEAPS represent long-term stock or index options that are available with expiration dates up to three years in the future, offering the option strategist a whole new set of trading opportunities because of their prolonged life. They usually trade in January and if a stock has LEAPS, then new LEAPS will be issued sometime in May.
There are several ways the trader can integrate LEAPS into their trading plan depending on the objective. They range from protecting existing stock, diversifying, or even several of the bullish and delta neutral type option strategies can also be employed.
If the objective is to protect an existing portfolio or stock then the trader certainly has some opportunities available to do so using LEAPS. For example, assume you are a long-term holder of stock XYZ but anticipate a potentially rough year coming up from an earnings standpoint, which will adversely impact the stock. However, you still want to hold on to the stock. What you can do, assuming XYZ trades LEAPS, is buy the at-the-money or slightly out-of-the-money Put approximately 1 year out which of course would be classified as a LEAPS.
Now for the cost of the premium you have hedged your stock and can only lose very little if the stock indeed drops mightily during the year. In addition, if during the year things start to turn around and now the stock appears to be stable you can go ahead sell the put getting back some of the premium since their will still be significant time value left. The trader can also use some of the combination strategies with LEAPS such as the bear call spread or the bear put spread to act as a long-term hedge against an equity holding.
Diversification is another key objective that can be achieved by using LEAPS. This can be done, especially if you have limited amount of funds, by employing deep in-the-money calls using LEAPS versus the out right purchase of the stock. By getting deep enough in-the-money the option essentially moves nearly point for point with the changes in the stock. This requires far less capital outlay than purchasing the stock outright and allows the trader to diversify into more issues than would otherwise be possible. The key of course is to buy deep enough in the money to accurately simulate the purchase of the stock. When doing this you are essentially paying very little for time premium.
Many other combination strategies can also be employed with LEAPS whether they are directional in nature or are delta neutral. More often than not when using LEAPS with a directional bias you will do so by employing bullish strategies given the market has a tendency go up over time versus a bearish strategy which you would want to implement in a shorter time frame, unless your hedging of course.
Some of the bullish spread strategies that can be applied to LEAPS are the bull call spread and the bull put spread. The strategist can also employ the delta neutral strategies like the call ratio backspread and the long straddle. Finally, the volatility skew strategies like the calendar spread and the diagonal spread can also be employed. LEAPS are a tremendous trading vehicle and should certainly be explored by every option strategist.
Happy Trading.
Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
jeff.neal@optionetics.com
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