“LEAPS” and Bounds Ahead of the Market
This article takes a look at the pros and con’s of buying Long-term Equity Anticipation Securities (LEAPS) call options.
What are LEAPS?
LEAPS are long-term “call” options. A call option gives the buyer the right to purchase shares from the seller at a certain price (strike price). For this privilege, the seller receives an upfront premium payment from the buyer. At the end of the contract, if the option never went above the strike price, the seller keeps the premium and is not forced to sell the shares. What differentiates LEAPS from other call options is the duration of the option contract is much longer (> 1 year).
An option’s value has 2 components. The first is intrinsic value. This is the difference between the strike price at which the option can be exercised and the current price. On the date of expiration, with a strike price of $100, on a stock worth $105, the option’s value is $5. This is because you could “call away” the shares at the $100 strike price, sell them back to the open market for $105, and you would pocket the $5 price difference.
The second component in the price of the option is the time value. For the duration of the contract, the seller is taking on the risk that the stock’s value moves above the strike price, and they miss out on all those gains. For the seller to be willing to take on this risk, the buyer must be willing to pay a duration premium above the intrinsic value. This time value plays a significant role in the cost for LEAPS because of the lengthy duration of the option’s contract.
Why would you want to buy LEAPS?
One reason is leverage. Since the option premium is less than the cost of purchasing the shares outright, the movement of the stock, in absolute terms, is divided by a smaller value.
Say that you purchase a long-term option for $20 on a stock worth $100 at a strike price of $100. If the stock price moves up 1% during the day to $101, the value of the option should go up by 1$ as well. Since the change happened so quickly, you can assume that the time value of the option hasn’t changed, but the intrinsic value has increased by the same 1$. This $1 gain on the $20 purchase price results in a 5% change in the value of the option (1/20=5%).
The other advantage of a call option is putting less capital at risk. In the example before, if the stock price went to $0, you would only lose your $20 premium rather than the full $100 purchase price of the share.
Foot Locker Example:
Back in May of this year, I purchased some $FL LEAPS. I felt like the share price was well below the intrinsic value of the company, and the share price was highly likely to increase at some point in the next year.
I bought when the share price was around $30 with a strike price of $30. I paid a premium per share of $5.36. Since the strike price was so close to the current price, the premium was almost all time value (0 intrinsic value). The expiration date of 01/19/24 gave me ~20 months for the price to converge closer to where I thought the intrinsic value was (~$48). The share price jumped to $39.50 in September. I sold my calls for $12.14 per share. In this instance, the stock price went up 33%, but the option’s value rocketed up 126%.
How can it go wrong?
My biggest issue with LEAPS is the duration component. If it takes the stock’s price longer to converge on intrinsic value than the duration of your contract, you can be in trouble. You run the risk of being right about the stock price, but lose all your option’s premium. For this reason, I also like to go out as far in time as I can on the length of the options contract. I try to get more than 18 months. Identifying potential catalysts for changes in the stock price that are inside your time horizon can also be helpful.
The other major problem is that leverage cuts both ways. In our first example ($100 strike, $100 price, $20 premium), if the share price drops to $99, you have a 5% drop in the value of the option(-1/20). To combat this issue, I like to ensure a significant margin of safety between the current price and the strike price. In the $FL example, the stock was trading below book value (P/B=0.9) and I felt like I had a 60% discount to fair value. This meant the stock didn’t need to get all the way back to fair value, and I could still turn a profit. This idea is not a panacea though. In The FL stock price dropped to $26 before it rocketed back up.
Summary:
Buying long-term call options can be a great way to create leverage and increase your returns without using margin. Because the option premium is less than the price of the stock, the value of the option appreciates at a faster rate than the stock itself. However, this leverage hurts you just as much in the downward direction. It is also important to consider the duration risk and be willing to lose all your premium if the market price doesn’t close to the strike price within the duration of the options contract.
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Note that this article does not provide personal investment advice and I am not a qualified licensed investment advisor. All information found here is for entertainment or educational purposes only and should not be construed as personal investment advice.
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