Buying Too Much Time with a LEAPS Vertical Spread

 

Option traders for the most part, are taught when buying options, make sure you don’t buy options with too little time left to expiration so time decay will be less of a factor. Buying too much time is not always a bad thing but sometimes it can affect the profitability of the trade. Let’s assume a trader is looking at a stock that he thinks will rally but he is not sure when. To be on the conservative side, the trader decides that he will purchase Long-term Equity AnticiPation Securities (LEAPS) call options, which will provide hopefully more than enough time for the stock to move as expected. LEAPS have a huge time value associated with their premiums so to lower the cost you might choose to implement a bull call vertical spread by selling a higher strike call option with the same expiration. A bullish call Vertical spread will reduce the cost of the trade but it will also reduce potential gains.

Option traders need to know how time value and deltas change in regards to the overall position change. LEAPS have expirations of over nine months. The spread’s options contain significant time value and the option’s deltas are all close to .50 which almost negates any potential stock move.

If the stock starts to rise, both the long and short options won’t move much. Most LEAPS spreads have relatively small net deltas of 0.10 or less. What that means is that for every dollar the stock moves up, the net change of your position will be only 0.10.

Google Inc. (GOOG) is a relatively expensive stock and the options can be pricey as well especially on LEAPS. When GOOG was trading at about $500, a trader could enter a LEAPS bull call spread that would expire in January 2013, giving the trade a little more than 500 days to expiration. The trader could have bought a January 2013 520 call and sold a January 2013 550 call for a net cost of $14 and maximum gain of $16. LEAPS also tend have higher bid-ask spreads because they are not traded as often which can make the cost of the trade more expensive as well.

The net delta on this vertical spread is only 0.06 which means that currently for every dollar GOOG moves up the spread will only gain $0.06. Even if GOOG jumps up $10 which it is capable of doing, the spread only profits by a little over $0.60.

Buying more time isn’t always a mistake but many option traders tend to overlook the trade’s net delta. Remember to always calculate the spread’s net delta and don’t expect gains immediately when the price starts moving in the trader’s direction especially with a small delta. If the move is expected to come in a month or less, try to avoid using long-term option such as LEAPS.

Dan Passarelli

dan@markettaker.com



  • Cameron

    Good article. Thanks for sharing. Still working the ins-and-outs of delta regarding LEAPs. Is it a good idea to set up vertical spreads using LEAPs prior to an Earnings Report when the volatility has spiked?