You might have not heard of LEAP options, but you’ve mostly likely heard of a very successful example.
In early 2021, Reddit user in /r/WallStreetBets Keith Patrick Gill (better known as /u/Deep(expletive)Value or DFV) made headlines for turning a $53,000 investment into nearly $50 million in one year by betting big on GameStop. Keith achieved this by employing a LEAP (Long-Term Equity Anticipation) option strategy.
A LEAP option is a long term option that expires anywhere from 1 to 3 years out from the current date. This allows for a buy and hold strategy that has a much higher potential payoff than simply buying the stock. This will be the ultimate guide on LEAP options.
Please note that this guide primarily focuses on LEAP calls (or a long call position) as opposed to using LEAP puts, although the same theory applies.
Why Use a LEAP Option vs. a Short Term Option
Many options traders will purchase contracts that expire within a month, a few weeks, or even a few days. While the payoff can be huge for short term options, it can be similar to buying lottery tickets as no one can predict the stock market in the short term. That’s not to say short term options aren’t useful for options trading, but a LEAP option will be the weapon of choice for an investor that’s looking to mimic a buy-and-hold strategy for the underlying security. Below are pros and cons on LEAP options vs. short term options:
- Longer time value than short term options – you’ll have time for your investment thesis to play out rather than rely on short term swings. You can also potentially execute a poor man’s covered call strategy with a LEAP option.
- Potential of the same asymmetric return profile as short term options – we will illustrate using DFV’s GameStop investment as an example below.
- Less volatility compared to short term options due to LEAP options having a longer time horizon.
- Often more illiquid than short term options. This often results in a wider bid-ask spread.
- Not available for all stocks – some stocks have options but not LEAP options.
- Options premium can be high compared to short term options. Because LEAP options have more time value than short term options, they can be much more expensive per contract.
LEAP Option Potential Payoff Illustration (At Expiration)
As with all options, your payoff at expiration is basically the intrinsic value and payoff before expiration is the intrinsic value + extrinsic value. Although an extreme example, let’s return to the story of Keith Gill (DFV) and GameStop. Between June 2019 and September 2019, he spent approximately $53,000 on LEAP call options expiring January 15’ 21 with a strike price of $8.00. He bought 1000 contracts with the options premium averaging to about $0.53. The stock was trading around $3.00 to $5.00 during that time frame.
Come January 2021, GameStop exploded to a peak of $380 a share. If Keith had just invested in the stock, he would’ve gotten approximately a 94x return (assuming an average purchase price of $4.00 a share), or $5.0 million. But with the LEAP options, his return was about 700x, or an intrinsic value of approximately $37.0 million.
It’s worth emphasizing that this type of returns is not your typical LEAP options scenario, but clearly demonstrates the potential of LEAP options versus just investing in stocks.
How to Identify LEAP Option Opportunities
The GameStop saga is an anomaly, but there are still ways to discover very lucrative LEAP option opportunities based on fundamental analysis. Here are two tips on how to identify a potential LEAP option winner:
- Blood Running in the Streets – “The way to make money is to buy when blood is running in the streets”. This quote from John D. Rockefeller applies in wake of the post-pandemic economic rebound. Hindsight is 20/20, but there were many opportunities in March 2020 (i.e. travel stocks that were beaten down and stocks that benefited from the pandemic). Even in a post-pandemic recovery, there are still opportunities lying around. For example, I wrote an article on Sprouts Farmers Market (SFM) in October 2021, where I thought it was trading at an attractive value and could also be an interesting options play.
- Market Disruptors – If a company has the potential to disrupt an industry, investors could be willing to pay a large premium in anticipation for its future earnings. For example, Tesla (TSLA) trades at far higher valuations compared to its peers. Critics propose that it’s in a bubble, but proponents such as Cathie Wood states that Tesla can completely reshape the automotive industry. People who invested in Tesla LEAP options a year or two ago would have enjoyed massive gains.
Market disruptors have massive upside. Although it can be easy to identify companies that have a novel idea, finding one that can bring that idea to fruition and execute is difficult and is sometimes part luck and part skill.
The Dangers and Pitfalls to Avoid When Using Long Dated Call Options
Although LEAPs are great tools to leverage long term investments, there are dangers to avoid when using LEAPs:
- Overpaying or selling too low due to illiquidity. The bid ask spread could be very wide for a LEAP option. If you simply buy at the ask price or sell at the bid price, you could be overpaying or under selling significantly. Always use a limit order so that you can sell at a fair value.
- Buying too far out of the money. It can be dangerous to buy a contract that is too far out-of-the-money. Don’t let greed of how much money you could make if the underlying hits incredibly high cloud your judgement. Most of the time, it’s best to purchase a LEAP option with a strike price that a Company can realistically achieve.
- Over investing in a position. Although LEAP options have a longer horizon, they still expire. Your timing could be off even if your thesis is right, so be very careful about putting all your eggs in one basket with LEAP options.
Executing a Purchase of a LEAP Option
While every brokerage is unique (here is a comparison of two popular brokers, Etrade and Robinhood), their interfaces should all require the same basic steps one must take to purchase or sell an options contract. The first two steps below are for any options contract, but number 3 and number 4 relate specifically to LEAP options.
- Enter Ticker Symbol and Select Options – Search for your desired stock’s ticker symbol, just like you would for a stock (for example Sprouts Farmers Market = SFM). Select “Options” – Usually, the default trading screen will be for traditional stock trading. Find a tab for “options” and select.
- Choose Details – You should now be looking at an options chain ( a list of options with strike prices for a specific expiration date – see table below). To choose a LEAP option, select an expiration date that is at least one year out from the current date. You should see charts for call/put contracts for the expiration date with a strike price running down the middle.
- Define Limit Order – as mentioned above, one of the most important aspects of purchasing a LEAP option is recognizing the bid ask spread can be wide due to illiquidity. Once you’ve selected your strike price and expiration date, you should set a limit order. Limit orders allow you to set a specific price to buy or sell a security. LEAP options are often illiquid so the bid ask spread can be huge. In fact, the asking price sometimes makes no sense, so you have to set a limit price or you’ll be overpaying for the option.
Source: An example of an LEAP options chain from E-Trade
Rolling a LEAP Option
Rolling a trade is a strategy that traders use to help manage a winning or losing position. It involves closing a position while simultaneously opening a new position for the same underlying stock with a later expiration date, strike price, or both.
- If you are winning, you can use this strategy to take profits off the table while extending your investment in the position. You would essentially sell your LEAP call option for a profit, and roll it out to a longer expiration date at a higher strike price. The option premium to roll the position should be lower than what you sold your existing options for.
- If you are losing, this could be a strategy to extend your time for your option. You could sell your LEAP call option for a loss, and buy another longer dated option. This effectively replaces your existing option contract at a loss, in the hopes that your replacement contract will perform better
Utilizing LEAP options can be an excellent way to get leveraged returns on longer term investments. It’s less speculative than short term options but can offer the same type of outsized returns. With solid fundamental analysis and careful selection, LEAPs can be a great tool for an investor.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.