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Because most option traders live in 15-45 days-to-expiration land, there’s a myriad of factors they have to take into account when considering a trade in LEAPS options which aren’t present in short-term options. Implied Volatility is Higher in LEAPS Because of the long time to expiration for LEAPS, they carry higher implied volatility levels. This is intuitive, as in standard times, the VIX term structure is typically in contango, meaning future months get more expensive as you go into the future. Here’s an example of the VIX term structure at the time of writing, which is in contango: In other words, more can happen in more time. So the price of uncertainty goes up with time and hence the IV on LEAPS is expensive. Furthermore, there’s less selling pressure in LEAPS from option sellers. Premium sellers tend to pick shorter-dated options (<15 days) so they can quickly recycle their capital quickly. Selling LEAPS ties up your capital for long periods in exchange for a marginal increase in yield. It’s generally a bad trade, at least when it comes to systematic premium selling. They stay out of LEAPS and that keeps the IVs in LEAPS high. It might be obvious, but the best time to buy LEAPS is when the VIX is below its long-term average, and ideally when the underlying stock has a low IV Rank. The general consensus among academics who study volatility is that it clusters and trends in the short-term and mean-reverts in the long-term. For this reason, buying LEAPS at a low VIX and IV Rank puts extra wind at your back. Interest Rates and Dividends Actually Matter The average options trader lives in 15-45 days-to-expiration land. They seldom need to think hard about how their positions are impacted by the distributions of dividends, or changes in interest rates (Rho). But when it comes to LEAPS on a stock that pays a dividend, there’s going to be several dividend payments throughout the life of the option, and as we well know, interest rates can change dramatically over the course of 1-3 years. While these factors are mostly priced into market prices already, future changes in rates or dividends can impact your position in ways you don’t understand if you go into LEAPS blindly. Below is a chart from Lawrence McMillian’s excellent book Options As A Strategic Investment displaying a series of expirations and how their pricing differs with changes in interest rates. Note that the bottom line is value at expiration. And here’s a chart from the same book displaying how changes in dividends affects call option pricing: These two factors are of special importance in 2022’s market environment of rising interest rates and energy being the leading sector. Due to a myriad of factors, energy companies often choose to distribute earnings as dividends in lieu of investing in growth as tech companies might. Traders holding LEAPS in energy equities have probably learned a thing or two this year. LEAPS Have Far Less Liquidity Besides having less interest from option traders, market makers are generally less active in LEAPS and tend to quote very wide spreads. This can make establishing a position of any reasonable size a pain. Because option prices have definitive and knowable characteristics allowing you to ascribe a theoretical fair value to them, it’s far easier to get someone to trade with you if you’re will to pay a premium to the theoretical value. However, as good traders often say, getting into a trade is seldom a problem, getting out when out when you need to is the issue. How Traders and Investors Use LEAPS? Position Trades Many short-term traders who are used to holding their positions in the area of hours or days don’t like to/aren’t experienced at managing a longer-term delta-one position. Instead, they’ll often use LEAPS to express these longer-term views. Whatever their initial risk (perhaps 1% of their trading equity) would have been on the trade, they’ll use that to buy LEAPS, which they can kind of “set and forget” and not fiddle with stop losses and gap risk. This has the added benefits of providing leverage to their positions as well as not tying up much of their capital for long periods. An Alternative to Index Investing Whatever you think of the Boglehead philosophy of index investing being nearly the only way to invest smartly, they’ve had a pretty good track record for the last few decades when compared to actively managed fund options. But skeptics of passive investing still have a problem with blind faith in long-term return averages continuing into the future, but don’t want to miss out on potentially amazing yield. One way to replicate a return profile similar to that of passive index investing is to use LEAPS on index ETFs like SPY by periodically rolling at-the-money calls forward and funding the negative carry with the dividends supplied by a modestly sized high-yield dividend portfolio. Enhancing Returns of Long-Term Holdings Many hedge fund managers for whom their largest position is asymmetrically larger than the rest of their positions are presented with a problem. They’re loaded up to full size and then the position declines in value, creating an excellent opportunity to buy more at a great price. But they don’t have the capital or simply can’t risk more on what is already their largest position. In this case, they might use LEAPS to increase their upside for a small relative cost. Betting Against a Short Seller’s Nightmare Tesla (TSLA) is the perfect example of a stock that many traders desperately want to short exposure to, but the volatility is simply too high. There’s a whole graveyard of long/short managers who got taken to the cleaners shorting Tesla (TSLA). This is where buying LEAP puts would be a viable alternative. You still get the upside if your thesis is correct In the situation of Tesla, the bet was binary in nature for many of the company’s skeptics. They’re sure that the company is an eventual zero and if not unless they can find a strategic buyer like Volkswagen before the worst happens. Do note that this isn’t our view, instead, we’re just explaining the thinking of many Tesla shorts. In a binary situation like the one above, the put premium paid isn’t even of much concern if you expect such a dramatic move to the downside. The only concern is timing, of which LEAPS provides plenty. There’s a number of stocks in the same camp as Tesla in that the volatility is too difficult to deal with. Protecting Long-Term Positions Just as the Tesla bear might opt to use LEAPS calls to express their bearish view in a risk-defined manner, the Tesla bull might, too. With a stock like Tesla being such a high-risk, high-reward bet, even the bulls are aware of the significant risks to their thesis. For them, the trade is semi-binary in nature as it is for the shorts, at least far more so than buying the S&P 500 is. This is where they might use out-of-the-money LEAPS to protect their worst case downside while still benefiting from the same upside. Bottom Line While LEAPS aren’t very popular among traders due to opportunity cost on capital, they provide an excellent avenue for traders to limit their risk while making long-term leveraged bets. It’s for this reason that LEAPS are frequently overpriced, because there are few natural sellers. If you dip your toe into LEAPS, make sure you take heed of the differences between LEAPS and short-term options: Lower liquidity Higher IV Dividends and interest rates actually have a significant impact on LEAPS positions.

The question here is: What is better, 11 or 1.5? Many will be surprised at the answer: 1.5 is better. Yes, $150 is preferable to $1,100, given the time to expiration. To illustrate this point, consider three LEAPS short options, all on Chevron (CVX) and based on the closing price as of February 12. The stock closed that day at $92.55, so the comparison is made between 92.50 calls for different expiration dates. Assuming a covered call is the selected strategy, the bid prices of calls for these three options are shown below: January 21, 2022 (342 days) 92.50 call bid 9.90. Based on current stock price, the return is: 9.90 ÷ 92.55 = 10.70% June 17, 2022 (489 days) 92.50 call bid 11.10. Based on current stock price, the return is: 11.10 ÷ 92.55 = 11.99% January 20, 2023 (706 days) 92.50 call bid 11.25. Based on current stock price, the return is: 11.25 ÷ 92.55 = 12.16% These returns seem healthy enough. All are in double digits. The problem is that the positions must be held open for such a long period of time (11 months, 16 months, and 23.5 months). This not only ties up a trader’s capital, but it also prevents taking other opportunities that might arise during this length holding period. The dollar value of these calls is healthy, but when the returns are annualized (restated as though the holding period were exactly one year), the true yield is not as positive: January 21, 2022 (342 days) 10.70% ÷ 342 days * 365 days = 11.42% June 17, 2022 (489 days) 11.99% ÷ 489 days * 365 days = 8.95% January 20, 2023 (706 days) 12.16% ÷ 706 days * 365 days = 6.29% These returns are still not that bad, but compared to shorter-term covered calls, they are dismal. For example, based on the CVX price at the close of February 12, consider three options expiring within one month, both for initial return and annualized return: February 26, 2021 (13 days) 1.54 ÷ 92.55 = 1.66% Annualized: 1.66% ÷ 13 days * 365 days = 46.61% March 5, 2021 (20 days) 2.12 ÷ 92.55 = 2.29% Annualized: 2.29% ÷ 20 days * 365 days = 41.79% March 12, 2021 (27 days) 2.44 ÷ 92.55 = 2.64% Annualized: 2.64% ÷ 27 days * 365 days = 35.69% From this summary, it is apparent that the shorter-term covered calls are more profitable on an annualized basis than any of the LEAPS contracts. If a trader were to write one 2-week covered call 26 times over the coming year, as close to the money as possible, the overall net return would be far higher than writing one call for one to two years out. There are other advantages to taking in a stream of relatively small dollar amounts rather than using the LEAPS calls. The longer-term covered calls will be less responsive to intrinsic value changes, than short-term contracts. Of even more importance, with the 2-week option, time delay will be rapid, and chances for profitability are much higher. As expiration approaches, time decay accelerates, especially during the final week. For example, between the Friday before expiration and the Monday or expiration week, only one trading day passes; but three days of time decay occur. On average, options lose one-third of their time value between these three days. Writing options every two weeks demands close monitoring to avoid exercise if the underlying price moves the option in the money. In this event, the option can be closed or rolled. The act of rolling forward is not part of the ideal plan for achieving the double-digit returns gained by a high volume of covered call writing. It could be preferable to accept exercise, meaning the premium is all profit, and the trader can then purchase another 100 shares, either of the same underlying or another one, and begin the covered call writing process over again. An expansion of the short-term covered call strategy is to use the ratio write. In this approach, more calls are sold than can be covered. For example, a trader owns 200 shares and sells 3 calls at the money. It may be viewed as two covered and one uncovered call, or as three partially covered calls. This is a moderate risk strategy. It generates more income than the one-to-one covered call, but risks exercise as well. To modify the risk, the variable ratio write is a sensible alternative. In this case, two strikes are used. For example, a trader owns 200 shares at $92.55 per share. A variable ratio write is opened combining two 92.50 calls and one 95 call. The OTM call can be closed if the underlying price begins to rise, and if the two-week approach is used, chances are good that this will result in a small profit or breakeven. The less volatile the underlying, the lower the risk, and the lower the premium a trader will receive. This requires a balancing act between risk and reward (as all options trades do). Being aware of how annualized return will change perceptions about covered calls, and which ones are most profitable. Many novice traders go immediately to the longest-term LEAPS they can find, attracted by the much higher premium. When the math is studied and the true annualized returns are compared, short-term options make more sense. The overall return is further enhanced when the underlying pays an exceptional dividend. For example, CVX yields a dividend of 5.16% per year. This by itself is impressive, but when added to the annualized yield of covered calls, it is irresistible. For example, the 13-day option in the previous example yielded annualized return of 46.61%. Adding the dividend of 5.16%, the overall net return is 51.77%. That is a difficult level of net return to match anywhere else. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.