Talking about LEAPS, not short dated options.
I'm still learning options (don't be too harsh 🙂 ), and I'm pretty sure this strategy probably exists and must have some name, but it's a conclusion I've come to myself and I may be missing something.
Scenario: I'm bullish on a stock (that I already own and wouldn't mind increasing my exposure to), and I speculate with some high-volatility period sometime in the near future. Some numbers (not totally made up, but rounded):
If I have $1000, and the stock is trading at $20, I can get 50 shares. If at some point trades at $30, that's $10 gain per share = $500 gain, with a max loss of $1000 if the stock goes to 0.
Instead, I can also buy a single contract for 100 shares for a premium of $10 with a $10 strike, with a 0.95 delta and 0.98 gamma. That makes a cost basis of $20. For every dollar that the stock moves up or down, I'm +$95 or -$95 on my contract. If at some point the underlying trades at $30, that makes 10 * 95 = $950 + changes caused by volatility, with a max loss of $1000 if the underlying trades at $10 or less.
Is this an strategy that may make more sense if you're willing to take more risks? Is a high gamma something to take into account in this case?
Edit: bad math
If you're bullish,does it make more sense to buy deep ITM calls (delta~1) instead of the underlying?
byu/el_juli inoptions
Posted by el_juli
7 Comments
Makes sense to me. I’d buy the leap at least one year DTE….and on a pullback or red day.
Then I’d sell covered calls against it. Poor man’s covered call.
You haven’t mentioned Time decay as a risk…. Just because they’re Laos doesn’t mean you can ignore it.
Read “Intrinsic: Using Leaps to Retire Early” by Mike Yuen. It’s basically this. Leveraging yourself on a company you believe in. It’s a straight forward read and makes it all make sense.
I can buy 100 shares of a certain stock worth $20 I’m bullish on for $2000 OR I can buy 3 contracts with a $17 strike price mid 2026 for $2200. Im getting exposure to 300 shares rather than only 100. Granted my delta isn’t as high as your example but the point still stands. His book is exactly your method. Using DITM LEAPS to leverage a position.
He basically says choose a strike price with a break even no greater than 5% of current underlying price, that way your delta is anywhere between .9 and 1. More people don’t do it because it’s not as quick and flashy to 2x or 3x your money, and it’s a lot more expensive than OTM options. For GOOG if you had 20k you’re wanting to invest, then you could buy 126 shares. Or you could buy 2 contracts for an $86 strike price that expire in 823 days. Obviously the less ITM your strike price the more leverage you get. If you chose ATM strike price of $155 then you’d be able to buy the exposure to almost 600 shares (6 contacts) over the next 2 years. Obviously this works for cheaper companies as well but it’s “safer” on the big stocks if it seems like a good entry.
Not sure why no one else is mentioning it, but your math is off. You do get leverage by buying the leap, but not anywhere near the amount that you’re implying.
If you buy shares at $20, you can buy 50 shares with $1k. Your pnl at $30, as you calculated is $10 x 50 = $500.
If you buy the 10c for $10, you control 100 shares. This would imply that you control twice as many shares, so your pnl should be double at $30. Indeed the calls would be worth $20 at $30. Since the multiplier is 100 and you paid $10, your pnl would be 100 * (20-10) = $1000. Double the pnl of buying shares.
But yes, you also risk max loss if the underlying goes down 50% instead of 100% so there is that.
long story short: No.
You buy the options ONLY when you expect the realized vola to be higher than implied. Doesn’t matter whether they are leaps or not. To get that extra benefit from options you need to be right about the direction AND realized volatility.
And how are you getting 9500 usd with 10usd movement of the stock?? Isn’t 95*10 = 950usd? Make sure you can math first.
The “Stock Replacement Strategy” is where you buy one high delta deep ITM call LEAP instead of 100 shares. Because it is deep ITM, if the implied volatility is reasonable, you’ll pay minimal time premium (even less if there’s a dividend).
– Their lower cost enables you to leverage your cash
– LEAPs have very little time decay (theta) for many months which means that the daily cost of ownership is low.
– On an expiration basis, the call LEAP has less catastrophic risk than share ownership if share price drops below the current stock price less the cost of the LEAP. Below the strike price, the shareholder continues to lose whereas the call owner loses nothing more.
– Prior to expiration, the LEAP has less risk than the underlying because as the stock drops, the call’s delta drops which means that the call LEAP will lose less than the stock. How much less? Not much initially. It depends on how deep ITM the call LEAP is, when the drop occurs (soon or near expiration) and what the implied volatility is at that later date.
– If the underlying rises nicely, you can roll your call up, pulling money off the table and lowering your risk level, something you can’t do with long stock. You’ll give up some delta but in return you’ll repatriate some principal and possibly, gains. The disadvantage of rolling up is taxation if it’s a non-sheltered account (unless it’s your intent to create taxable events).
DISADVANTAGES:
– The amount of time premium paid
– LEAPS tend to be illiquid and therefore they often have wide bid/ask spreads so adjustments can be costly. Try to buy them at the midpoint or better and use spread orders for rolling them.
– The share owner receives the dividend and the call owner does not.
– If the underlying has dropped a lot, implied volatility is likely to be higher, making them more expensive to buy.
– LEAPs do not trade after hours (though you can defend them by buying or shorting the underlying).
If you still like the upside potential of the stock, roll your former LEAPs (they are considered traditional options when there is less than a year until expiration) before they enter the accelerated theta decay of the last few months before expiration.
If you follow all of this then the next leap (no pun intended) for some is an income strategy called the Poor Man’s Covered Call where you use the LEAP as a surrogate for the stock and you write OTM calls against it. Technically, this is a diagonal spread.
The options market is pretty efficient. If you buy long-dated ITM calls it reflects the implied future price of the asset plus financing costs.
The extrinsic value is just the cost of financing the trade for that duration plus whatever dividends or earnings growth are implied.