Not too long ago in my volatility crunch series (which starts here), I mentioned LEAPS in passing. Afterwards I realized: this is really a prime topic to discuss in a separate post, especially for beginning options traders.

What are LEAPS?

“LEAPS” stands for Long-Term Equity AnticiPation Securities, essentially an option with a much longer lifespan – 9 months or more - than the usual contracts. LEAPS can help you reap benefits similar to long stock ownership, while limiting the risks of actual stock ownership. Think of LEAPS like Equal to sugar: a “stock substitute”.

Rule of thumb #1: Go deep-in-the-money

In researching LEAPS, first find an underlying stock that interests you. You can use the same process you always use to evaluate stock before purchase.

Now for step 2: choose your strike price. (If you’re not familiar, a strike price is the price at which your option is activated. If you’re holding a call, you have the right to buy stock at the strike price; if a put, you have the right to sell at the strike.)

You want to go deep in-the-money for your LEAPS strike. In other words, if we’re talking about a call, you’re “in-the-money” when your strike price is lower than the current stock price. Think of it this way: if you had the right to buy stock at 50 when the general market price is now 55, you’d be feeling pretty plush, right? That’s “in-the-money” in a nutshell.

Rule of thumb #2: Look for deltas of .80 or more

A good rule-of-thumb is to look for a strike price with a delta of .80 or more. If delta is a brand-new concept to you, I’d suggest you check out my earlier series on delta (which starts here). In short, though, a delta of .80 simply measures how much the options contract will theoretically rise for every rise of $1.00 in the underlying. If stock X goes up by $1, an option with a delta of .80 should go up 80 cents in theory. If delta equals .90, then the option should go up 90 cents (again, in theory) for every $1 rise in the underlying.

You can find deltas easily when you use TradeKing’s Options Chains tool under Quotes + Research. It’s the third column from the left for calls:

 
As a starting point, consider a LEAPS call that’s at least 20% of the stock’s price in-the-money. Translation: on a $100 stock, that means you’re aiming for a call with a strike price of $80 or lower. However, for extra-volatile stocks, you may have to go deeper in-the-money to get the delta you’re looking for.

Word to the wise: the deeper in-the-money you go, the more expensive your option is going to be. The reason for this is that very in-the-money options have lots of “intrinsic value” – they could be exercised right now and the intrinsic value could be captured. The other kind of value in an option’s price is called “time value” or “extrinsic value”. Most options usually have some time value, but it obviously tends to dwindle as expiration approaches and time dries up. Deep in the-money-money options will usually have quite a bit more intrinsic value than time value.

At least there’s an upside: in-the-money options might be more expensive, but they’ll also have those high delta values you’re looking for. Think of it this way: a high-delta stock is going to move more or less the same amount as the underlying stock does. If we’re thinking of LEAPS here as a “stock substitute”, that’s exactly what we’re aiming for. You can have something that “acts” like stock, but at a much lower cost to you than buying the stock outright. The downside is that the LEAPS options do still expire eventually, albeit much further down the line than shorter-term options. Usually stock never expires.

Next week we’ll continue with a few more rules of thumb on LEAPS…stay tuned!

Regards,
Brian (OG)

[image: Leap:Tikal by the mat on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.