How to use Leaps option strategy effectively?
Did you know that legendary investor Warren Buffet uses Leaps options strategically to buy his favorite stocks and indexes?
Leaps options are a great tool for someone looking to leverage on going long a stock or index. Leaps option if used correctly can enhance return on capital and provide additional income while limiting portfolio loss.
What is a Leaps option?
Long-term Equity AnticiPation Securities. Leaps are long-term call and put options with expirations from 7 months up to three years in the future.
The longer dated options offer great benefits to strategic investors who want to maximize their portfolio returns.
Why use Leaps at all?
Leaps cost you about 50-90% less in price than stock, providing potentially greater return.
As a result of lesser capital investment compared to outright stock purchase, you are looking at bigger profit potential.
Limit losses to the premium paid on the Leaps option. Buyer has limited loss to the extent of the premium paid. This too could be recovered, if you strategically sell short term out of the money options on the same underlying.
Ways to use Leaps options
Buy Leaps Call : you would do this to go long on your favorite stock or index. You could buy a Leaps call and wait for the underlying to go upwards – making you rich !
Buy Leaps Put : you would buy a Leaps put to protect against any downfall in the underlying. This is like buying a long term insurance on your stock/index holding.
Sell Leaps Call : you would want to sell leaps call if you know that the stock or index is about to go down and you see juicy premiums on the call side.
Sell Leaps Put : Warren Buffet uses this strategy to bring down his cost of ownership in Coca Cola. In this instance, you become the Insurance company. Selling out of the money put options to buyers for a premium will bring in decent cash. This cash can be deployed to good use further. When the time comes, if the stock is below the strike price of options sold, you end up buying the stock. Cheaper way to buy stock !
How to buy and sell Leaps
Your broker platform should have Leaps listed in the option chain tab. Look around for any option that has an expiry of more than 7 months at least.
If you intend to buy 100 shares of the stock or index, buy one call. If you intend to buy 200 shares, buy two calls, and so on.
When it comes to selling Leaps options, make sure you have enough margin required.
Leaps option strategy
stock replacements : buy leaps call instead of buying the stock/index itself. Cheaper and less riskier!
Covered call writing: buy leaps call and sell monthly/weekly call at a higher strike. This is similar to covered call writing where you buy the stock itself with full cash and then write out of the money options. With leaps call you are paying only a fraction of what it would cost you to buy stock.
Spreads: Calendar spreads, diagonal spreads, vertical, horizontal etc. too complicated for this article – check out recommendations listed below.
Issues with Leaps options
Liquidity : Not all Leaps options are liquid enough. While Index options are, stock options may not be as liquid.
Bid ask spread : because of liquidity issue, the bid and ask spread with large on these options. The ideal way to approach this issue is to place a bid at the mid point of bid and ask prices. If for example you see bid and ask of 18/20, then placing an order at 19 increases your chance of order fill.
Patience : for an active trader, leaps options may not appeal as it requires a lot of patience.
Best Leaps options to buy
Consider going long on leaps options on stocks that are fundamentally good. OR consider broad based index leap option. Why not imitate Warrent Buffet and consider Coca Cola? Or if you have any favorite stock which you think is fundamentally good – go ahead and check out if Leaps is listed for it. If yes, consider investing partly on it.
Here’s link to check out Coca Cola Leaps options
Leaps options are a great tool to an advanced investor. Someone who wants more bang from his/her investments at lower risk.
With leaps you get to control larger portfolio with less capital.
The only challenge is your patience. Once you have initiated a Leaps options strategy, it is time to play the waiting game. Your patience will be tested.
You need to have predefined entry, exit and stop loss points.
Below are some of the resources from amazon to help you know more about Leaps:
Options as a Strategic Investment: Fifth Edition
AIM for Millions with Stock Options: The Safe and Reliable Method for Profitable Investing with Long Term Stock Options (Leaps)
Understanding Leaps: Using the Most Effective Option Strategies for Maximum Advantage
Investing with LeapsS: Choices in Long-Term Options (Wiley Trading Video)
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I wish you well.