LEAPS is a long-dated CALL or PUT option contract that allows us to leverage on time to benefit when the share price of the underlying stock rises or drops respectively. The longer the expiration date, the higher the premium we pay for the same strike price. In this article, I will share why it is not a good idea to hold your LEAPS until expiration.
Let’s start off with OTM LEAPS. Assuming you bought a Tesla LEAPS, with a strike price of $2,475 and an expiration date on 20 Jan 2023, with a delta of 0.15. You bought this LEAPS when Tesla was trading at $1,000 and paid a premium of $40.
Over the course of one year, Tesla continues to rise until it hits $2,474 on 20 Jan 23, which is a share price gain of $1,474, which would translate to $1,474 x 0.15 = $221 premium price gain (assuming there is no time decay and delta remains constant). That would be a 552.5% ((221/ 40) x 100) return of investment if you choose to sell your premium on 20 Jan 23. However, if you allow it the contract to expire and because it does not meet the strike price, the contract will expire worthless and you lose your premium of $40 x 100 = $4000 that you paid. instead of gaining $22,100 in profits.
This scenario can happen for ITM or ATM LEAPS options as well, when the share price stays stagnant or drops below the current price over a period until the date of expiration. As long as the share price does not exceed strike price on expiration date, the contract expires worthless and the buyer loses all of his premium.
What If The Contract Expires In The Money?
Let’s assume that in the above example, the contract expires in the money as the share price of Tesla closes at $2,476 on expiration day, 20 Jan 23. It means as a buyer, you will need to buy 100 units of Tesla at $2,475 (strike price). That would mean that you need to get ready $247,500 capital to buy 100 units of Tesla shares. If you do not have $247k in your account, your brokerage will liquidate your other holdings, i.e. sell away your existing shares to raise capital or put you on margin and charge you an interest for lending you money first.
Even when you have the money to buy 100 units of the underlying shares with it hits strike price, it does not mean you have made a profit. You will still need to factor in the premium that you paid upfront. Using the same example, the breakeven price of the Tesla contract is $2475 + $40 = $2515, which means Tesla has to rise to $2,515 in order for you to break even. Therefore, you can see that instead of earning $22,100 by selling off the contract before expiration, you ended up with $4,000 of paper loss when the share price hits just above the strike price and the contract expires in the money (ITM).
This second scenario can happen for ITM or ATM LEAPS options as well, when the share price just exceed the strike price barely on the date of expiration. When that happens, the buyer will need the extra cash to honour the contract and at the same suffers a paper loss roughly equivalent to the premium paid.
When buying an option contract, it is important to keep track of the expiration date and to react accordingly (take profits or cut loss) and not allow it to expire or be exercised automatically on expiration day and lose all the potential gains. You can also read about how to mitigate the risk of trading LEAPS options in this article and prevent yourself from getting into undesirable situations.
How Does LEAPS Works?
Understanding How CALL Option Works
What Is In-The-Money (ITM), At-The-Money (ATM) And Out(of)-The-Money (OTM)?
4 Reasons To Close An Options Contract And How To Do It
My Guiding Principles Of Buying LEAPS
The Risks Of LEAPS Options Trading & How I Mitigate Them
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2 thoughts on “Why Holding LEAPS Option Till Expiration Is A Bad Idea”
Real good piece of info. Theta decay will also cause the bought option to lose more value over time- the closer we get to expiration, the lesser the value ( extrinsic value becomes lesser over time) of the option is gonna be priced at.
Yes Chris, you are absolutely right, Theta decays exponentially in the last 30 days. In this example, we are assuming Theta does not change so as not to add too many variables and instead place the focus on the subject matter.