Those who have followed my writing on investing over the years know that I use options as part of my investing approach. There are various kinds of options and many ways options can be applied depending on what an investor or trader is trying to achieve. The question that I receive most regarding options is how I use LEAPS. Given the high interest, I will focus on LEAPS and one way I have applied them in my own investing.
WHAT IS A LEAPS?
A LEAPS is an options contract that has an expiration date with more than a year remaining from today’s date. There are LEAPS that can have more than 2 years of time remaining. The most common expiration date for LEAPS is the third Friday of the first week of January, but there are also LEAPS that have expiration months other than January. Usually, January LEAPS first become available in September about 2 years (28 months actually) prior to their expiration. For example, January 2023 LEAPS first started trading in September 2020. The January 2022 options were of course also still available when the January 2023 options first became available, and both are still considered LEAPS because there is more than a year before the expiration. However, once an option has one year or less until the expiration it ceases to be considered a LEAPS.
GROWTH STOCKS AND WHY USE LEAPS
As I mentioned, there are many applications for options. In this post, I am focusing only on one application: using call option LEAPS on a growth stock under a specific situation. Let me be very clear: I rarely use this approach as certain conditions need to be met first. Buying call options are more risky than buying shares.
In this application of options, I buy (buy to open) a call option on a stock instead of buying shares in that stock. Alternatively, I may also choose to sell shares that I already own in that stock and use the proceeds to buy LEAPS (i.e. converting shares to LEAPS). When I buy the LEAPS or convert shares to LEAPS, it’s because I believe that there is a very high likelihood that the shares of the company will rise significantly in the coming 12-24 months. LEAPS provide a way to control more shares for the same amount of capital invested, and, if the shares of the company rise significantly as I predicted then the LEAPS will earn a higher percentage return than just owning the shares.
THE POTENTIAL DOWNSIDE OF LEAPS VERSUS SHARES
Like all options, LEAPS have an expiration date; there is a finite amount of time for the underlying shares to move in the direction that you are expecting. If the underlying shares move in the opposite direction or don’t move up enough then the options trade will fail completely or underperform compared to having just bought the shares. Shares, on the other hand, have no ticking clock and can be held indefinitely through selloffs and long periods of prices not moving much. Since an investor must pay a premium for buying a call option and since the call option will have no value if the shares ultimately end up at or below the option’s strike price, it is possible to lose the ENTIRE investment in a LEAPS. Again, by owning shares you do not have this risk as you can just wait out a downturn or an extended sideways move. This time limit risk is real and should not be taken lightly. For this reason, I will usually only buy a call option LEAPS under certain conditions as outlined below.
WHEN I BUY LEAPS ON GROWTH STOCKS
As discussed above, there can be greater benefits as well as more risk in buying call option LEAPS, therefore, I am careful about when I will buy them. Below are the two conditions that need to be met both of which serve to give me a very high level of confidence that the underlying stock will rise significantly within the next 2 years.
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- Long-term growth of the company is intact (in my opinion)
- The shares are undervalued (in my opinion)
Let’s begin by looking at the first condition. When managing a growth stock portfolio and deciding in which companies to allocate and how much to allocate into each position, I look at a number of financial metrics and also consider a number of other factors to arrive at a decision. I’ll go into the weeds on how I do this in a future post, but I will point out that first having done a deep dive on a company is the foundation on which all my options trades and investments decisions rest; without a solid working knowledge of a company’s financials, market position, market dynamics, leadership, etc., etc., etc., I would consider stock investments, options investments, or options trades akin to gambling. Furthermore, I have to convince myself that the company is so good that I think that it will likely continue its past success going forward for a least a couple of years. The more convinced I feel about this, the more likely that I will be willing to invest in a 15-28 month call option LEAPS; also, if my confidence is very high, I will likely to invest a larger portion of my portfolio into such an options position. I love it when the important financial metrics that I track for a company are stable and/or accelerating to the positive.
The second condition that I look for is that the shares, in my opinion, are undervalued. This is essential too because the shares must rise within a set period of time for my call option LEAPS investment to work out well. Valuation is a subjective thing. One investor may think that a stock is undervalued while a different investor may consider it to be overvalued. Each investor will make their own determination and take action or not on their assessment. I tend to invest in companies that many other investors think are highly overvalued. Clearly, I disagree with them if I’m willing to invest large allocations into these stocks. I consider myself to me a 95% investor and 5% trader, but I consider my investments into LEAPS to be investments and not trades. The primary difference is that for a trade I‘m betting on an assessment of a near-term trading/valuation prediction or an upcoming potential catalyst for a short-term gain while for an investment I am predicting a longer-term winner, which I believe will lead to stock price appreciation. My use of LEAPS pertains primarily to the latter. However, I’m aware that my long-term holdings trade in valuation ranges, move on sector and overall market sentiment, and rise or fall on specific news that can be completely unjustified or overly exaggerated. Thus, there can be opportunities when a stock that I have a high degree of confidence in can become undervalued, sometimes significantly so. In such a case, I may invest in LEAPS or convert shares into LEAPS.
To recap, the first condition is an absolute prerequisite for me to consider a LEAPS, and the second condition is the trigger to make the investment. The size of the LEAPS investment has to do with the degree of my conviction in the company and the degree to which I think it is undervalued.
Once I’ve decided to invest in call option LEAPS or convert shares to LEAPS, I’ll need to decide on the expiration date and strike price. I’ll go over how I decide that next.
HOW I CHOOSE THE EXPIRATION DATE AND STRIKE PRICE
The expiration date determines the amount of time remaining on the option before it must be closed out or exercised. If I buy (buy to open) a call option, I can it sell back (sell to close) at any time prior to the expiration date. I can also exercise the call option which would exercise my right to buy the underlying shares for the specified strike price. Thus, an option is a contract with a ticking clock, and when the time expires then the option contract is either exercised or it expires worthless and disappears.
Expiration Date
The amount of remaining time on an option is particularly important because the purchaser has to be right about the direction of the underlying stock price as well as the timeframe within when that move must occur. One can never be sure about the timing; I certainly can’t. Therefore, since I consider this an investment as opposed to a trade, I like to give myself a lot of time for the underlying stock’s price to do what I think it will do.
The types of stocks that I invest in are often quite volatile (tend to move up and down a lot) and can be subject to large declines before eventually making new highs. To illustrate this, consider that during the three-year period encompassing 2018 through 2020, my portfolio saw several large drops including one 45% drop in 2020, two 37% drops in 2018 and 2019, and one 27% drop in 2020. Now these drops were not just in one stock but in my ENTIRE portfolio; and since I am/was investing primarily in SaaS companies, the companies in my portfolio tended to drop as a group. These drops come with the territory when investing in hypergrowth companies, and I fully expect these drops to occur occasionally but I can’t possibly know when they will occur or how long they will last. Sometimes the portfolio bounces back quickly as it did with the two 2020 drops and 2018 drop, but other times the drops can take a long time to completely reverse such as with the 37% drop in 2019 which took 179 days to recover to the previous peak (intraday) and 291 days to recover to the previous peak using closing prices. In other words, I can’t emphasize enough, the importance of minimizing the risk of getting caught in a big drop without having enough time to recover within the time window remaining prior to expiration. Drops in a stock can be non-specific (total market drop), sector specific (e.g. all SaaS companies drop as in a sector rotation), or company specific (only the stock for which I own the call option LEAPS drops as might happen in response to company specific news). The drop can occur for any of these three reasons, but, in each case, more time serves to maximize the change of the stock recovering after a drop and before the options expires. Therefore, I usually choose the option with the most time remaining. One exception where I may consider a less costly call option LEAPS with less remaining time is immediately after a massive drop, but weighing the cost-benefit of the incremental cost for extra time on an option is something that each investor can do to determine what is best for him/her.
Another consideration when choosing the expiration date is capital gains taxes. In a taxable account in the United States, long-term capital gains apply on investments held for a year or longer. This rule also applies to gains on options. The tax rate difference between a long-term capital gain and short-term capital gain may be significant. Therefore, an investor in a call option LEAPS may want to consider a possible or probable future taxable event as a factor when choosing the option’s expiration date. In addition, an investor may want to build in extra time beyond 1 year to allow a several months’ time window to exit the position in the event there is a temporary drop in the stock price.
Strike Price
When thinking about which strike price to select, my main considerations are the following:
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- The likely future price range of the underlying shares (in my opinion)
- The probability of the various future prices within the price range of the underlying shares (in my opinion)
- The premium that I must pay for options on various strike prices I’m considering
Let’s examine the above. As a reminder, I usually will only buy LEAPS if I believe that the price of the underlying shares will probably rise in the upcoming 12-24 months. Therefore, my opinion of the range of price outcomes will include a range from the current price on up. I find it helpful to use a MicroSoft Excel spreadsheet to create a payoff table with various call options LEAPS in rows (also one row for shares) and various future prices of the underlying shares in columns. Below is a payoff table example that I created when CRWD shares were at $58.15 during the first week of April 2020.
| CRWD Jan22 Strike Price | Price per share | Shares | Gain @ $60 | Gain @ $100 | Gain @ $120 | Gain @ $200 |
|---|---|---|---|---|---|---|
| CRWD shares | $58.15 | 1720 | $3181 | $71,969 | $106,363 | $243,938 |
| CRWD $47.5C | $20.50 | 4878 | ($39,024) | $156,098 | $253,659 | $643,942 |
| CRWD $55C | $17.25 | 5797 | ($71,014) | $160,870 | $276,812 | $740,580 |
| CRWD $57.5C | $15.65 | 6390 | ($84,026) | $171,565 | $299,361 | $810,543 |
| CRWD $60C | $15.40 | 6494 | ($100,000) | $159,740 | $289,610 | $809,091 |
| CRWD $70C | $11.25 | 8889 | ($100,000) | $166,667 | $344,444 | $1,055,556 |
| CRWD $80C | $9.00 | 11111 | ($100,000) | $122,222 | $344,444 | $1,233,333 |
| CRWD $90C | $6.05 | 16529 | ($100,000) | $65,289 | $395,868 | $1,718.182 |
| CRWD $100C | $4.55 | 21978 | ($100,000) | ($100,000) | $339,560 | $2,097,802 |
To keep the comparisons on an apples-to-apples basis, I chose an arbitrary amount of $100,000 to calculate the number of shares or share-equivalents that would be controlled by the hypothetical $100,000 investment. For the options prices, I simply took the midpoint of the bid and ask; bid/ask spreads for LEAPS are typically wide, and I find that the midpoint of the bid/ask gives a close approximation for the price that you can actually purchase a LEAPS option contract. Next, I simply divide each price into $100,000 to arrive at the number of shares or share equivalents. To calculate the payoff, I simply multiply the number of shares (or shares controlled for the options) by the in-the-money value of the options. You will notice that the higher strike price options give a much higher return if the shares rise significantly, but these higher priced options also require the shares to rise quite a bit to avoid a total loss of the initial investment. Shares provide the lowest upside but the highest margin of safety. In choosing the strike price, I tend to be conservative and purchase LEAPS near the money (i.e. strike price near the price of the stock at the time of purchase). I know investors who are even more conservative and buy LEAPS that are deep in the money for an increased margin of safely. The deeper in the money the call options LEAPS are the closer they are to buying actual shares. Of course, an investor can choose to spread out his/her LEAPS investment across a spectrum of strike prices. Ultimately, each investor must decide if they want to purchase LEAPS at all, and, if so, the appropriate strike price may depend on his/her risk-reward appetite.
NO DIVIDENDS ON OPTIONS
Some shares pay quarterly, semiannual, or annual dividends on shares owned. Holders of call options on such shares do not receive dividends. The growth stocks that I typically own do not pay regular dividends anyway so it is not usually a consideration. However, whether an underlying share pays a dividend or not is something that each investor should consider before using LEAPS as an alternative to owning shares.
EXITING THE LEAPS AND TAXES
Since LEAPS have a finite time, they must either be sold back or exercised prior to their expiration; in the worst case, the LEAPS expire worthless for a total loss if the strike price is at or below the share price at expiration. Thinking about the exit of the options at the time of purchase can be helpful particularly when contemplating the purchase in a taxable account. Selling the options may be a taxable event if there is a capital gain and if the account holding the investment is in a tax domicile where capital gains are taxed. In some domiciles, investments held for less than one year and investments held for one year or more are taxed at different rates; such rate differences may be an important consideration when selecting the expiration date of a LEAPS. I usually like to leave myself at least a few months of wiggle room to sell the call option LEAPS back so that I have more than a few days or weeks to close the position AND still have a long-term capital gain.
I also think about time value decay when setting my exit plan for the LEAPS. When purchasing an at-the money LEAPS on a growth stock it can be typical to pay a 25-35% time value premium (percentage of the share price). In the CRWD examples above, the closest strike price to the price of the shares was $57.50 (when the shares were at $58.15); this option was priced at $15.65 and had $0.65 of intrinsic value; therefore, we would need to pay $15 in time value for 21.5 months of time on shares that were $58.15; this calculated to 15/58.15 or about 26%. If the shares rise a lot and the LEAPS become very deep in the money then the time value will virtually disappear. However, if the shares stagnate and end near the strike price then there will be a good amount of time value left on the call options even several months prior to expiration. At that time, an investor can make the decision to cut his losses and salvage the remaining time value before the time value decay rapidly accelerates in the weeks leading to expiration.
In general, if the plan is to sell back the call options to harvest the profits (as opposed to exercising the call options in order to take the shares), I have found it prudent to consider closing the options positions several months prior to expiration. It is even more prudent if the shares have just had a strong rally; it would be a shame to see profits vanish by getting caught in a big market selloff, a sector rotation, or a stock-specific FUD event in the weeks prior to expiration as there would be little time left for the shares to recover.
One way to defer a capital gain is to exercise the call options instead of selling the options back. The benefit is that exercising an option to purchase shares in usually not a taxable event (check with your accountant). In order to avoid a short-term capital gain, I find it important to decide whether or not I plan to hold the shares for at least another year before deciding to exercise a call option because the shares received by the options’ exercise will have a purchase date on the date that the shares are acquired by the options’ exercise and not the date that the LEAPS were originally purchased (again check with your accountant to verify that this rule applies in your country’s tax jurisdiction). Another drawback to exercising the call options to purchase the shares is that the exercise requires the investor to deploy additional capital into the investment.
Since the call option LEAPS allow the investor to control more shares for the same amount investment, it is a form of leverage. Leverage cuts both ways as it amplifies returns to the upside and to the downside. If the LEAPS preform very well because the underlying shares increased, an investor can consider if the shares are still undervalued, are fairly valued, or have become frothy. Unwinding the leverage of the LEAPS and converting them back to shares is one way to lock in and protect some of the amplified returns when the investor thinks that the shares have run up too far, too fast.
SUMMARY
Buying call option LEAPS can provide a way to amplify upside when an investor believes that the underlying shares have significant growth ahead and are currently undervalued. I believe that the optimal time to execute such a tactic is when the company’s growth prospects are very strong for the next several years and the shares are very undervalued. Growth stocks periodically have large drops from peak prices. Sometimes such drops can be 30-40% or more. If such a drop has just occurred WITHOUT any change in the company’s fundamentals, then this could be a golden opportunity to buy call option LEAPS or convert shares in to LEAPS. In addition, if the whole sector and/or the whole market has also just experienced a big selloff then my confidence in buying LEAPS is even higher. During the past 4 years, I have been primarily invested in SaaS companies, and in the past 3 years there have been very large drops of my portfolio:
- peak: 9/4/18, bottom (-37%): 12/24/18, recovery: 2/27/19
- peak: 7/26/19, bottom (-37%): 10/22/29, recovery: 2/18/20
- peak 2/18/20, bottom (-45%): 3/16/20, recovery: 5/12/20
- peak 10/13/20, bottom (-27%): 11/10/20, recovery: 12/17/20
In hindsight, the bottoms have been excellent times to buy LEAPS or to convert shares to LEAPS. Psychologically, it can be very difficult to pull the trigger at a bottom because the drops can be distressing and one never knows for sure when the drop will end or how long the recovery will take. It is possible for a 37% drop to turn into a 60% drop, and it is possible for a recovery to take several years which could be more time than a LEAPS can offer. Shares provide you with unlimited time to wait it out while LEAPS can provide significantly more upside but also carry more risk. Each investor must to decide for himself how he wants to position himself on the risk-reward spectrum. I don’t give anybody advice and I am not advocating using LEAPS, but I hope that you find this post thought provoking.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.