What are the characteristics of this option strategy?
Leap option strategies (LOS) pair long-dated out of the money calls with the sale of an equal number of out of the money puts to help finance them. The result is a synthetic long position: the short puts are naked, so the downside is not defined and the loss can run down to the put strike plus the net debit paid if the underlying collapses. This strategy expresses a bullish view. Long call plus short put is a synthetic long position with a delta near +1.00, so it profits on a rally and loses roughly dollar for dollar with the underlying on a decline, while a flat market simply decays the long call. The advantage of this strategy is that the investor can set up a long-term position that gives them plenty of time for the stock to move into the money. The long horizon means fewer routine adjustments than a monthly spread requires, but the position is not one to leave unattended: the naked short put has to be monitored and managed if the underlying breaks down.
Is this a bullish, bearish or neutral strategy?
The LOS is a bullish strategy, not a neutral one. Long call plus short put is a synthetic long, so the combined delta sits close to +1.00 and the position tracks the underlying almost one for one. The purchase of long-term OTM calls gives the investor open ended upside, while the sale of OTM puts brings in premium but obligates the investor to buy the stock at the put strike, adding downside risk rather than protection. The trade works out only if the underlying rises far enough to cover the net debit by expiration.
Is this a beginner or an advanced option strategy?
The LOS is an advanced option strategy. It requires a good understanding of options pricing and volatility, and because it involves writing a naked put it also requires a margin approval level that most beginner accounts do not have, for good reason.
In what situation will I use this strategy?
The LOS is most suitable for investors who want multi-year long exposure to a stock they are willing to own outright, and who would accept assignment at the put strike if the shares fall. It is not a sideways market trade. A flat market simply decays the long call while the short put slowly earns its premium. Being long the call gives positive Delta but negative Theta, since time decay works against a long option. The only positive Theta in the package comes from the short put, so net time decay depends on which leg carries more extrinsic value.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The LOS has open ended reward and open ended risk. Above the breakeven the long call gains without limit; below the put strike the short put loses dollar for dollar with the shares, all the way down to a worst case of the put strike plus the net debit paid if the stock goes to zero. That is the same downside as owning the stock, taken on with none of the capital committed up front, which is why the position must be sized against the assignment value rather than the option premium. Higher underlying volatility raises the cost of the long call and the premium on the short put at the same time, and widens both tails.
How is this strategy affected by the greeks?
The LOS is affected by Delta, Theta and Vega. Delta measures the rate of change of the theoretical value of the option with respect to changes in the underlying stock price. Theta measures the rate of change of the options theoretical value with respect to time decay. And Vega measures the rate of change of the option theoretical value with respect to changes in volatility. Overall, the purchase of long-term OTM calls offset with the sale of OTM puts gives a strongly positive Delta. Net Theta is not automatically positive: the long call decays against the position, the short put decays in its favour, and the sign depends on which leg carries more extrinsic value.
In what volatility regime (i.e VIX level) would this strategy be optimal?
The LOS is most optimal when the VIX level is low, below 20. The lower the VIX, the lower the volatility and the lower the cost of the option. This means that the investor can maintain the long-term position for a longer period of time without having to adjust the position or purchase new options.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
The long horizon gives plenty of time to adjust, but it also means a losing position can be carried for years, and the margin requirement on the short put rises as the stock falls. One way to adjust is to buy back the short put and re-sell it further out in time at a LOWER strike, which moves the assignment level further away, or to buy a protective put below it so the downside is capped. This will allow the investor to increase the probability of profit and also increase the Delta benefit from the long-term OTM call.
Where does this strategy typically fall in the range of commissions and fees?
The commission and fees associated with LOS will depend on the brokerage and services they provide. Usually, brokers offer a tiered commission structure which will be cheaper when the size of the order increases. The total cost of a LOS trade can range between $20 to $50.
Is this a good option income strategy?
No. The LOS is a directional bullish position opened for a net debit, not an income strategy. The only premium collected is the credit from the short put, and that credit is small next to the assignment obligation it creates. Traders who want income from long-dated options should look at covered calls or cash-secured puts held against the cash to buy the shares.
How do I know when to exit this strategy?
Exit the LOS when the long call has captured the move the trade was opened for, or roll it further out in time to keep the exposure. The more important exit is on the other side: because the short put is uncovered, a break below the put strike should trigger either buying the put back, rolling it lower, or accepting assignment and holding the shares. Waiting for expiration with a deep in the money short put is how a manageable loss becomes a large one.
How will market makers respond to this trade being opened?
When market makers respond to a trade being opened, they will usually adjust the bid and ask prices to attract buyers and sellers. They will be looking to match people who are buying and selling the same option contracts, and long-dated LEAPS series are usually thinner, so the bid/ask spread is wider than on near-dated options.
What is an example (with calculations) of this strategy?
Let’s consider a LOS strategy involving the stock of XYZ Company at $50/share. An investor can buy 1 XYZ $50 call expiring Jan 21, 2023 and offset the cost of the option by selling 1 XYZ $50 put expiring Jan 21, 2023. Assuming the XYZ Jan21’23 $50 call and put option are trading at $10 and $7 respectively, the cost of the LOS will be $3 ($10 – $7) per option contract. If XYZ finishes just above $50 at expiry, both options expire worthless and the investor loses the $3 net debit. The position breaks even at $53 (the $50 strike plus the $3 debit) and gains $1 per share for every $1 above that, so a close at $60 produces $7 per share, or $700 on one contract. The downside is where this trade demands respect. Below $50 the short put is assigned and the loss grows dollar for dollar with the stock: a close at $40 costs $13 per share ($1,300 on one contract), and a collapse to zero would cost $53 per share, or $5,300. One contract of this position controls $5,000 of stock for a $300 debit, so it should be sized against that $5,000, not against the $300.
Where does this strategy typically fall in the range of commissions and fees?
The commission and fees associated with the LOS will depend on the brokerage and services they provide. Usually, brokers offer a tiered commission structure which will be cheaper when the size of the order increases. The total cost of a LOS trade can range between $20 to $50.
MarketXLS
Investors who are interested in options trading strategies such as LOS should research the options trading strategies available, as well as learn more about the risks involved. It is important to have a full understanding of options trading strategies before diving in and executing a trade. MarketXLS options trading platform is an excellent tool for options traders of all levels of experience. From beginner to experienced traders, MarketXLS helps users understand options better and size a position against the risk it actually carries.
Here are some templates that you can use to create your own models
Call Backspread Option Strategy
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Relevant blogs that you can read to learn more about the topic
What is the Risk Associated with Leap Options Investing?
Long-Term Equity Anticipation Securities – Leaps Options
Collar Option Strategy – A Synopsis
Collar Option Strategy – A Synopsis
Benefits of Being Delta Positive