Long-term call options are a core component of my growth-focused investing strategy, thanks
to their ability to magnify your returns with fairly limited risk.
And in my opinion, this makes them one of the best entry points for investors who want
to get started with some options trading strategies.
So in this video, we’re doing a complete walkthrough of the leaps options strategy.
My goal is to help you be comfortable enough with LEAPs to get started with this strategy
by the end of the video, even if you know nothing about options right now.
And that means we’re going to start with some basic information surrounding call options,
how they work and how they provide greater returns than investing directly into stocks.
Then, I’ll break down the LEAPs strategy and what differentiates it from other call
option strategies.
Finally, I’ll give you an important warning about LEAPS and some tips for navigating the
strategy if you choose to try it out.
Let’s get into it.
To simplify options as much as possible, there are just two types of options contracts: call
options and put options.
As an investor, you can either buy or sell these contracts, making a total of 4 basic
options strategies.
The LEAPS strategy involves buying call options, so to save us all some time and minimize any
confusion, we are going to completely ignore the other strategies for now so that we can
fully understand the basics of buying call options.
A call option is a time-sensitive contract that gives you the right to buy 100 shares
of an underlying stock or fund.
Keep in mind you purely have the option to buy these shares, you won’t be forced into
any purchases by owning the contract, and we’ll talk about that flexibility later.
But if you bought a call option for Apple stock, for example, as long as you own that
contract, you can use it to purchase 100 shares of Apple stock at a predetermined price.
This price is set when you purchase the options contract, and is known as the strike price.
So if you had a call option for Apple stock with a $100 strike price, and the stock was
trading at $130, you could exercise your call option by paying only $100 per share, even
though the stock is trading at $130 per share.
This is known as an “in-the-money” call option.
The stock is trading at a higher price than your strike price, which means it’s probably
profitable for you to exercise the contract and purchase the shares, and that’s a great
spot to be in.
On the other hand, if your call option had a $140 strike price, you probably wouldn’t
want to exercise it because you would be paying $140 per share when the stock is trading for
less.
Whenever the strike price is higher than the current trading price of the stock, it’s
known as an “out-of-the-money” call option.
Out-of-the-money call options can be a little riskier because you need the stock to move
higher to earn a profit or make it worth exercising.
Of course, as we said, you’re not forced into buying stocks just because you have a
call option contract.
In fact, you have a couple of different options after purchasing a contract.
First, you can exercise the contract, which you would probably only do when it is in-the-money.
If it’s out-of-the money, you might wait until the contract expires in hopes that the
stock price goes up and your contract eventually becomes in-the-money.
If the stock doesn’t move up, your contract will expire worthless because it’s pointless
to overpay for the stock, which is the risk of these out-of-the-money contracts.
The last option is selling that contract to somebody else, because they can be bought
and sold just like shares of a stock.
And to understand this, we have to understand what gives our call options value.
When you purchase a call option, you pay a cash premium, which is equal to the value
of the option.
The value of an option is a combination of both intrinsic value and extrinsic value,
both of which I’ll break down.
Intrinsic value is the value baked into the options contract based on the difference between
the contract’s strike price and the current price of the underlying stock.
Another way to think about this is the amount of guaranteed profit that the contract has
in it if you were to exercise it.
So if you think back on our Apple contract from earlier with a $100 strike price, it
has $30 of intrinsic value because that’s the difference between the strike price of
the contract and the current trading price of Apple stock.
If you exercised the contract, you would be guaranteed a profit of $30 per share.
Because intrinsic value requires that the strike price be lower than the current share
price, only in-the-money call options have this intrinsic value.
Out-of-the-money options have no intrinsic value because their strike price is higher
than the current share price, and inherently offer no profit if you were to exercise them.
Extrinsic value is much less cut and dry.
Extrinsic value is made up of things like time left on the contract until expiration
and the volatility of the underlying stock or fund.
Extrinsic value will be higher when there is more time left in the options contract
and when a stock has higher volatility.
Obviously, the time left on a contract will decrease over time, slowly eroding the extrinsic
value of a contract.
And this is why out-of-the-money contracts can expire worthless - their only value comes
from time and volatility until the stock price exceeds the strike price.
If you purchase a short-term call option and the stock price doesn’t increase, time will
expire fast and will take your extrinsic value with it.
So now that we’ve covered the basic components of call options, let’s take a look at how
they magnify your returns.
The reason that call options can be so powerful comes down to the fact that they give you
control of 100 shares of a stock without investing the money required to own those 100 shares
in full.
In other words, you can enjoy similar or even greater returns with much less money.
Let’s return to the Apple stock example.
Apple is currently trading at about $130 at the time of making this video, which means
it would take approximately $13,000 to own 100 shares of Apple stock.
Alternatively, for just $1,070, you can buy a call option with a $130 strike price expiring
on October 15th.
So let’s imagine by October 15th, Apple stock goes up to $150.
If you invested $13,000 to buy 100 shares, you would’ve turned that into $15,000, which
is about a 15% return.
In comparison, we know that the call option contract you purchased would now have an intrinsic
value of $20 per share, given that the strike price is $20 less than the hypothetical trading
price of $150.
We also know that any extrinsic value will have diminished to zero by the expiration
date, which means all that’s left in the contract is that $20 of intrinsic value.
So we can estimate that the value of the contract, which was $10.70 per share at the time of
the purchase, has increased to $20 per share for a total value of $2,000 in options premium.
At this time, you could sell your options contract and lock in the nearly 100% return
on your investment.
Or you can exercise the contract to buy shares, then sell some of those shares to realize
your returns, although this would require more capital.
In any case, you were able to secure the returns of 100 Apple shares for a fraction of the
price.
The call option strategy can also be used to reduce your risk, because in this example
you’ve only invested the $1,070 as opposed to the $13,000 to buy shares.
If the price of Apple stock fell significantly, you could lose much more money owning the
100 shares than you would if you just purchased a call option for a fraction of the price.
The downside is your option could expire worthless leaving you with nothing, whereas you can
hold shares for all eternity with the potential that the price recovers.
And that finally brings us to the LEAPS strategy.
LEAPS stands for long-term equity anticipation securities, but don’t let this poorly constructed
acronym confuse you.
Simply put, LEAPS is a lower-risk strategy compared to other call option strategies.
LEAPS involves buying deep in-the-money call options with expiration dates at least one
year in the future.
Both of these components have some pretty substantial benefits, so let’s take a look.
The first component is purchasing options that are deep in-the-money.
As we said earlier, this is when the strike price is below the current trading price of
the underlying security.
I personally love this deep-in-the-money strategy, because most of the option premium is made
up of intrinsic value.
This minimizes the impact of time and volatility on the investment, and it also means you need
the stock to move much less to make a profit.
To revisit the Apple example from earlier, we looked at a call option with a $130 strike
price.
The stock was trading a little over $131 at the time.
With the option premium at $10.70, you’re only getting about $1.50 of intrinsic value
with that option - the rest being extrinsic value.
That’s over $9 of extrinsic value that will erode over time, which means you need the
stock to move up quite a bit for you to break even and make a profit.
If we look much deeper in the money, we can find a call option with a $100 strike price.
At $32.80, this option has over $31 of intrinsic value, which means very little is left to
extrinsic value.
In contrast to the $130 strike price, this contract only requires that Apple stock moves
up 1% for you to make a profit.
Overall, the point here is to secure an options contract with a lot of intrinsic value and
very little extrinsic value.
By reducing the impact of time and volatility, you only need a small increase in stock price
for your option to become profitable.
The value of your contract will also fluctuate less over time as a result.
The next component to LEAPS is purchasing call options with expiration dates at least
one year in the future.
Because time can be such a dangerous influence on the value of your option contract, securing
yourself more time gives you a larger window for the underlying security to move up.
It’s very difficult to predict stock movements in the short-term, so these longer expiration
dates will improve your chances of success and profitability when investing with call
options, thereby lowering your risk.
Additionally, holding an options contract for longer than one year officially makes
it a long-term investment, which means it will be taxed as such.
If you trade call options within a 12-month period, you’ll be responsible for paying
short-term capital gains on those trades.
By holding it longer than 12 months, you’ll be eligible for the gentler long-term capital
gains tax, which will allow you to keep more of your profits.
So hopefully by this point you understand why call options can be a powerful strategy
for magnifying your investing returns.
Although call options can be intimidating and risky, the LEAPS strategy is a great way
to control and minimize the risks involved.
The longer time frame improves your likelihood of success and even gives you better tax treatment.
All of these reasons are why I think LEAPS make a great options trading entry point.
Before we wrap up, though, I want to emphasize one danger of the LEAPS strategy and share
some tips for approaching these call options.
This danger is that even though LEAPS ARE lower-risk, they are not risk free.
It is still entirely possible that a stock drops below your deep-in-the-money strike
price and you lose your full investment.
So this is important to keep in mind when considering the strategy, because it might
not be suitable for all types of investors.
However, I do have some additional tips for navigating LEAPS with reduced risk.
One strategy is to use LEAPS on total market index funds or ETFs instead of individual
stocks.
For example, the S&P500 index has a long and consistent track record of producing returns
of about 10% per year.
Although it may not be as exciting, a LEAPS strategy on something like the S&P500 can
still help you magnify the returns of the underlying index without taking on the risk
of individual stocks.
My next tip is to use limit orders with LEAPS, because deep-in-the-money call options typically
have lower trading volume.
This means the spread between what people are willing to pay and what people are asking
can be pretty far apart.
If you place a market order, you may end up paying a much higher price for the contract
than you expected, which could mean more extrinsic value included in the option premium, ultimately
adding a little bit more risk.
My final tip is to keep your eye on Delta when selecting a call option contract.
Delta is a number that tells you how much the value of your options contract will change
with a $1 change in the underlying security.
So if the delta is .9, you can expect your options contract to increase 90¢ when the
underlying security increases by $1.
In other words, with a higher delta, upward stock price movement will drive larger increases
in the value of your option.
Basically, the closer you get to 1, the more your call option will behave like the underlying
security.
Generally, delta will be higher the deeper in the money you go.
Of course, the cost of these options will also be higher, so that’s something to consider
when selecting between different options contracts.
I personally like to secure options with a delta around .9, although it seems like most
people recommend at least .8 or higher for the LEAPS strategy.
But that wraps up our look at call options and the LEAPS strategy.
If you guys have any questions, I will be more than happy to answer them in the comments
below.
And for more videos about investing and other finance-related topics, stay tuned, and I’ll
see you back here for another video next week.