LEAPS

Harrison Roth · 1994

Thesis

The defect in listed options was their short life: a contract that expired within about eight months could express only a trading view, while a contract lasting two or three years can carry an investment opinion, a hedge, an income program or a repair, letting an investor separate a view on direction from a view on time.

The main ideas

Long-dated options decay slowly, so a buyer needs to be right about direction and size of a move, but no longer about its speed.
A deep-in-the-money LEAPS call can stand in for shares at a fraction of the capital. Its true cost is the time value paid, not the premium.
Selling LEAPS against shares, or selling puts against cash, turns a long horizon into one large premium instead of a year of monthly decisions.
Protective puts, married puts, fences, synthetics and surrogates are rearrangements of the same two rights, so the cheapest equivalent structure is the one to hold.
Buying a LEAPS and selling short-dated calls against it owns the slow clock and sells the fast one, with a failure mode that covered calls on shares do not have.
A position can be reduced or repaired instead of held or sold outright.
Every trade should be written down before the order: thesis, structure, break-even, maximum loss, exit conditions and the date it must be rolled.

Direction without speed

Harrison Roth, the senior options strategist at Cowen & Co. and a longtime instructor at the Chicago Board Options Exchange's Options Institute, wrote the first book-length treatment of LEAPS, Long-term Equity AnticiPation Securities, which the CBOE launched in October 1990. A LEAPS is an ordinary listed option with a distant expiration: the right to buy, for a call, or sell, for a put, 100 shares at a fixed strike price until the contract expires.

Roth's case rests on how time value decays. An option's premium has two parts: intrinsic value, what exercising it would yield today, and time value, everything else. Time value erodes slowly at first and then steeply in the last two or three months. A short-dated option sits on the steep part of that curve; a two-year option sits on the flat part.

The consequence is that a buyer of a short-dated out-of-the-money call needs three things at once: the right direction, a large enough move and that move happening quickly. A two-year call removes the third condition. A view about a product cycle or a company's recovery is rarely an eight-week view, and the contract can now match it.

The seller's position changes the other way: a large premium received, and a liability that shrinks only slowly while the stock and volatility can move against it.

Implication: before buying any option, decide how long your view needs to play out, and choose an expiration that does not require it to happen faster.

Surrogate and replacement therapy

Roth's name for using a deep-in-the-money LEAPS call in place of shares is surrogate therapy. Because such a call is mostly intrinsic value, it moves almost point for point with the stock: its delta, the change in option price for each one-point move in the stock, is high. It costs a fraction of the shares, the unused cash can earn interest, and the loss is capped at the premium.

The requirements are strict. Delta must be high, time value a small part of the premium and expiration far enough away that the call will not become a short-dated option while the thesis plays out. As an illustration: with a stock at 50, a two-year 35-strike call priced at 18 holds 15 points of intrinsic value and 3 of time value. The cost of the substitute is the 3 points, not the 18. A cheap out-of-the-money LEAPS call is not a surrogate.

Replacement therapy applies the same idea to shares already held: sell the stock, buy the deep call and invest the freed cash. The test is arithmetic. Time value paid, plus dividends given up, plus commissions, minus interest earned on the freed cash, is the price of capping the loss.

Implication: before substituting a call for shares, compute that net cost over your actual horizon. If it is small, the call is a hedge that frees capital; if the call is heavy with time value, it is a wasting asset bought in place of a real one.

Writing LEAPS against shares and cash

Roth treats selling LEAPS as a way to be paid for commitments an investor is willing to make. A covered call, shares held with a call sold against them, lowers the cost basis by the premium and caps the upside at the strike. The LEAPS version replaces a year of monthly sales and rolling decisions with one sale. Its annualized yield looks smaller than a monthly writer's, and is often the more honest figure, because the monthly writer can collect small premiums while missing a large move.

Selling a LEAPS put against cash reserved to buy the shares is a paid limit order: the investor keeps the premium if the stock stays above the strike, or buys the shares at the strike less the premium. Sold without that cash, the same put carries the stock's downside on margin.

A covered straddle, shares plus a short call and short put at the same strike, collects both premiums but is not neutral: the investor is sold out if the stock rises and owns twice the shares if it falls. A covered combination sells the call above the market and the put below it, defining a band.

The operational risk is early assignment. A short call deep in the money can be exercised before a dividend, a year earlier than planned.

Implication: write LEAPS only against outcomes you would accept, and watch time value against upcoming dividends on any short call.

Puts, fences and rearrangements

A LEAPS put bought against shares is term insurance. The strike sets the floor and the premium is the deductible paid in advance. One two-year put replaces a series of short-dated puts, each of which pays the spread and restarts the clock. The strike should match the loss the investor cannot carry: an at-the-money put protects from the first dollar at the highest cost, while a deep out-of-the-money put is cheap catastrophe insurance that does not pay for ordinary declines.

A married put, shares and a put bought together, has the same payoff as a call. A fence, Roth's term for what is now usually called a collar, buys a put and sells a call against the shares so that the call premium pays for part or all of the put, trapping the position between the two strikes. A synthetic long, a long call and short put at the same strike, behaves like the shares themselves.

Roth's point is that these are not separate strategies but rearrangements of two rights, linked by put-call parity, the relationship that makes long stock plus a put equivalent to a call, adjusted for interest and dividends. When two structures have the same payoff, the one to hold is the cheaper after dividends, interest and bid-ask spreads.

Implication: when you have designed a position, find its equivalents and compare their costs before choosing which to hold.

Time is of the essence

Roth's name for a diagonal position is time is of the essence: buy a LEAPS call, then sell shorter-dated calls against it, selling another each time one expires or is bought back cheaply. The long contract decays on the flat part of the curve; the short contracts decay on the steep part. The investor owns the slow clock and sells the fast one.

The structure has a failure mode that a covered call on shares does not. Shares do not decay; the LEAPS does. If the short call's strike sits below the long call's effective break-even, a sharp rally can make the short call lose more than the long call gains, so the position loses on the move it was meant to profit from.

Two rules follow. Keep the short strike far enough above the market that the position remains bullish rather than a ratio in disguise. And stop selling short calls once the LEAPS itself has become a short-dated option, at which point both legs run on the same fast clock.

Implication: before writing a short call against a LEAPS, check that its strike is above the long call's break-even, and set the date at which the program ends.

Reducing and repairing

Roth argues that holding and selling are not the only choices. Affirmative action, in his usage, is a reduction: sell half the shares and write a LEAPS straddle or combination against what remains, so that the investor is paid on both sides and has turned a hold-or-sell decision into a band. Reduced-risk equity trading generalizes it: rewrite a stock position so that part of the risk is transferred, part of the upside sold and the remaining exposure sized to the account rather than to the original purchase.

Repair is the unhappy case. The stock has fallen and the investor does not want to sell. Selling calls, or a call spread, against the damaged holding lowers the price at which it gets back to even, at the cost of capping the recovery.

The same distinction governs averaging down. Buying more on a decline is rational if the reason for owning the stock is intact and only the price has changed; it enlarges a mistake if the reason has broken. Writing the purchase schedule before the decline is what separates the two.

Implication: when a position goes wrong, decide first whether the thesis survives. Repair or average down only if it does.

The worksheet

Roth's chapter on the best strategy does not name one. A deep call is best for stock exposure with a capped loss and no dividend; a cash-secured put for buying shares at a discount; a fence for keeping shares and dividends without needing the upside; a spread for a view that the stock will rise into a range; uncovered short premium almost never, for the reader he is writing for.

What makes the choice operational is a worksheet completed before the order: the underlying stock, the thesis in one sentence, the structure, the debit or credit, the break-even, the maximum loss in dollars, the stock price at which the thesis is wrong and the date by which the LEAPS must be rolled or closed. After the order, the same sheet records what would trigger an early exit, such as a surrogate whose delta has fallen too far or a hedge whose index no longer resembles the portfolio.

The mechanism is discipline. A two-year position reviewed only at expiration becomes a short-dated option bought too early.

Implication: write the exit conditions and the roll date before entering any options position, and review the position as its sensitivities change.

Limits

Long life has costs the strategies understate. LEAPS carry higher premiums and wider bid-ask spreads than short-dated options, and their greater sensitivity to implied volatility means a position can lose on the way to expiration even when the view on the stock is right.
Much of the book is dated. It describes 1994 margin and tax rules, a listing appendix that was obsolete within a few years and a market of a few dozen underlying stocks; the strategies still apply, but the operational details must be checked against current rules.
Index LEAPS hedge the market, not a portfolio. A put on a broad index protects against a market decline and leaves the investor exposed to any difference between their own holdings and the index.

You Can Be a Stock Market Genius — LEAPS used as concentrated leverage on a single well-researched idea.
Safe Haven + The Dao of Capital — the argument for paying for crash protection, which LEAPS puts provide as term insurance.