Why I Don't Buy LEAPS

by

Brad Castro

After all, LEAPS (Long Term Equity AnticiPation Securities) allow you to control blocks of 100 shares at a fraction of the cost of purchasing them outright. And since they don’t expire for anywhere from nine months to 2½ years, you’ve got plenty of time for the stock, and consequently your LEAP, to move higher. If the delta is high enough, enabling your LEAP call to closely match dollar for dollar moves upward in the underlying stock, you’re getting significantly higher returns on your original investment than actual shareholders would.

A lot depends on the strike price you choose when you buy LEAPS, of course. The deeper it is in the money (ITM), the higher the price you pay (for the intrinsic value of the LEAP) but the less time premium you pay and the more protection you receive from declines in the underlying stock. For example, if a stock is trading @ $20/share and you chose to buy LEAPS with a $10 strike price over those with a $15 strike price, the stock would have to fall twice as far—to $10/share—to wipe out all your intrinsic value).

And, as with regular call options, historical and implied volatility plays a significant role. Yes, the theta (daily time decay) is less for options farther out in time, but much of the value of the LEAP is determined by its recent and expected volatility. The higher the implied volatility, the more you’ll pay to buy LEAPS. [one reason why the bid-ask spread is so wide—see Drawbacks below—is that pricing the expected volatility of something up to 2 1/2 years away is more crapshoot than not.]

From a risk-reward perspective then, and depending on the individual stock, of course, simply purchasing an ITM LEAP on a quality company with an undervalued share price is probably a no-brainer.

And yet I resist . . .


THE DRAWBACKS

Objectively, I don’t believe that it's extraordinarily risky or reckless to buy LEAPS. But, aligning myself with my own personality and psychology, there are nevertheless three fundamental disadvantages that I see to a simple long LEAPS strategy.

• No matter how deep in the money you go when you buy LEAPS, you’re still buying time premium. I hate being on the buying side of premium. To some, it’s no big deal, a small price you have to pay in order to leverage your investing dollars and control more shares with less money. But to me, it’s a penalty. The underlying stock MUST go up by the amount of the time premium for you to at least break even. Yes, you can theoretically make a killing if the stock moves sharply higher, but if the stock finishes where it started, not only will you have wasted up to a year or two of your life, you’ll also have lost money.
• The Bid-Ask spread is severe, even on large, liquid stocks. This is two-fold: the farther away the strike price is from the current share price, and the farther out in time the option is, the wider the Bid-Ask spread will be. This is another penalty that only gets partially offset as the expiration date nears. Buying LEAPS as an investing strategy is an inherently long term approach, but you still may have legitimate reasons for wanting to exit a position well before expiration.

  What if your assessment of the company and its prospects change? What if you no longer consider it a suitable investment? Or, suppose the stock does perform well. Too well, in fact. Suppose it moves dramatically higher and you begin to feel that the stock might be overvalued. In either case, if you sell with a lot of time still on the LEAP, and especially if the strike price is still significantly away from the current share price, you’ll get to leave a big, juicy tip for the market makers on your way out.

• LEAPS also suffer from what I term an “Inverse Volatility Effect.” Many technical traders take the VIX into account as a short term contrarian indicator. The VIX is an indicator that tracks overall market volatility. Because market declines tend to occur more rapidly and violently than the slow and steady upward march associated with bull markets, market bottoms, or at least short term market bottoms, often correspond to a spike in VIX readings. And likewise, a market top, especially in the short term, will almost always be associated with VIX readings at the low end of its historical range.

A similar dynamic occurs with LEAPS. In a typical value investing mindset, it would seem that the best time to purchase a LEAP is after the underlying security has already fallen substantially in price. But if the stock has recently fallen substantially, then its corresponding implied volatility will most likely have risen. Consequently, the option is more expensive to purchase.

And conversely, if a LEAP option is relatively cheap to purchase, it’s cheap because its implied volatility is low, which might be an indication that the underlying stock is closer to a top than a bottom.

In the end, I don't buy LEAPS because LEAP calls are still long calls, and long calls are an uphill battle. The underlying stock not only must go up for you to make money, it must also go up for you to break even. Yes, due to longer term expirations, LEAP options are arguably much smarter purchases than comparable near term options. But I still find that LEAP options have enough disadvantages on their own to keep me from ever wanting to buy any as part of a straight, buy and hold leveraged purchase.

That’s not to say that there’s no room whatsoever for LEAP options in a trader or an investor’s portfolio. It's just that LEAPS seem much better suited as components of trades or positions a little more complex than a simple buy and hold strategy.

For instance, when used as part of intelligent and informed calendar spreads, I think LEAPS provide a tremendous opportunity to generate significant returns.

Additionally, two specific Leveraged Investing strategies I detail in The Essential Leveraged Investing Guide rely on LEAPS.