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