With the stock market at historic highs and volatility close to all-time lows, some investors are considering taking their gains in their stock and ETF positions and buying long-term call options called Leaps (Long-term Equity Anticipation Securities).
Leaps expire 12 to 28 months out and can reduce losses when the inevitable correction comes, and, if the stock price rises enough, they also allow for buyers to participate in the appreciation.
Options trading isn’t for everyone; even a seemingly prudent strategy can go wrong, with investors losing everything that they initially invested, or more. With that in mind, the Leaps strategy can be a less-costly alternative to buying “put” options—a bet that a stock will decline—as insurance on a stock.
Let’s use the example of Yum Brands (YUM). Consider an investor who buys the $97.5 strike calls expiring January 2021 for $900 for a 100-share contract, or $9 a share (Leaps, incidentally, generally expire only in January and June).
In this case, buyers participate in any price appreciation gain above $106.5 (97.5 plus 9) over the next year. That would be a good result for a payment of less than 10% of the full cost of the stock.
How it works
If the stock declines, the call buyer’s loss is limited to the initial premium paid. Of course, if the stock is stagnant, the cost of the option might be more than any small profit or loss the stock incurred.
And keep in mind that with Leaps, as with any option, buyers forgo dividends, in this instance about 1.7%.
“That makes Leaps more attractive to stocks that pay little or no dividend, and less attractive to stocks with high yields,” says Interactive Brokers chief options strategist Steve Sosnick.
Leaps can be more difficult to price accurately, even for sophisticated investors, than short-term options. Leaps also tend to have higher implied-volatility levels embedded in them, and the trading activity and open interest (or contracts outstanding) can be low or even nonexistent.
“The spreads are significantly wider in the options than the stock,” Mr. Sosnick says. “Buyers should use limit orders and try to buy them inside the posted asking price.”
Pricing challenge