If you are thinking of buying LEAPS (long-dated CALL/ PUT option) for that magnified gain, it is important to understand the risk that comes with LEAPS so that you can make a more informed decision.
LEAPS can magnify your capital gain as the premium price gain rises much faster than the existing share price gain. So, in a bull market or when a company’s share price is increasing, the % gain is a few times that of the % share price increase. We can use delta, existing share price and the premium paid to calculate the expected growth, based on a simple LEAPS Growth Formula.
However, when the market turns bearish or when the stock prices start to fall, the % premium loss will also be magnified and that is the risk of trading LEAPS options. If delta stays constant through the drop in price, the expected % drop of premium relative to the expected % drop of share price can also be calculated using the growth formula shared in the above para.
Let’s illustrate this concept with an example.
Example: Apple LEAPS
Current share price: $150
Expected Growth = 0.5 / (15/ 150) = 0.5 / 0.1 = 5
This means that whenever apple drops by 10% in share price, your LEAPS premium will increase by 50% in a premium price.
How is that possible?
Say Apple drops by 10% in share price, which is $15, so using a delta of 0.5 (Delta is the amount an option price is expected to move based on a $1 change in the underlying stock), the premium should decrease by $7.50.
If you take $7.50 / $15.00, it is a 50% decrease in a premium price.
In reality, when the share price drops, the delta of the contract will drop and the Implied Volatility (IV) will rise and these 2 factors help to support the premium price and prevent it from dropping faster than expected. Having said that, the LEAPS Growth Formula and the example illustrated above are still good estimations of how much faster the premium will drop in comparison to the share price loss.
LEAPS options have unlimited upside and limited downside. The maximum loss that a LEAPS options buyer can suffer is the maximum amount of premium paid, which may happen when the stock keeps free-falling until it drops to zero. For options traders who buy OTM LEAPS like me, do note that you will lose all your premium if you allow your LEAPS options contract to expire Out of The Money.
How Do I Mitigate These Risks With My LEAPS Contracts?
There are a few ways that I use to mitigate the risk of my LEAPS contract expiring worthless and me losing all my premium.
Strategy 1: I close my LEAPS contract way before it expires
Since most of my LEAPS contracts are OTM LEAPS CALL, there is a high probability that they will expire worthless at the expiration date. Therefore, I will close them way before they expire, i.e. I will sell my LEAPS CALL option contracts at least half a year before they expire when I have the chance to do so (when there is a profit).
Strategy 2: I buy longer-dated LEAPS contracts to withstand correction and stomach the price fluctuations along the way
I buy LEAPS contracts that have an expiration date between 1.5 years to 2 years. In the event of a market correction, there will be time for the stock to recover and for me to turn profitable. As theta (time value of options contract) decays exponentially in the last 30 days, I have ample time to wait for the share price to recover.
Strategy 3: I buy LEAPS on fundamentally strong companies
More than 86% of my LEAPS contracts are in fundamentally strong companies such as Alphabet, Apple, Microsoft, Facebook, Netflix, Tesla, AMD and Nvidia. These companies are fundamentally strong, have huge cash reserves and are among the most valuable companies in the whole world. They are likely to be more resistant to a market correction and will rise in price over time.
Strategy 4: I average down on my LEAPS if they keep falling
In a big market correction, the premium can drop significantly and I use the opportunity to average down on my LEAPS positions and own them at a lower average premium price. That allows me to break even faster when the share price rises again.
Strategy 5: I buy OTM LEAPS
This may seem unconventional but my maximum loss will be lowered as the premium that I pay is lower in prices, to begin with. Also, with OTM LEAPS, the delta will be lower, which means the premium will drop at a slower rate when the share price drops.
Understanding How CALL Option Works
How Does LEAPS Works?
What Is Implied Volatility (IV)?
What Is In-The-Money (ITM), At-The-Money (ATM) And Out(of)-The-Money (OTM)?
Why I Buy LEAPS With A Low Delta?