LEAPS
Options buyers have time working against them. With each passing day,
theta erodes the value of their assets. Buying a long-term option, or a
LEAPS, helps combat erosion because long-term options can decay at a
slower rate. In environments where there is interest rate uncertainty,
however, LEAPS traders have to think about more than the rate of decay.
Consider two traders: Jason and Susanne. Both are bullish on XYZ Corp.
(XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60
call at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example,
May options have 44 days until expiration, and the LEAPS have 639 days.
Both of these trades are bullish, but the traders most likely had slightly
different ideas about time, volatility, and interest rates when they decided
which option to buy. Exhibit 7.1 compares XYZ short-term at-the-money
calls with XYZ LEAPS ATM calls.
EXHIBIT 7.1 XYZ short-term call vs. LEAPS call.
To begin with, it appears that Susanne was allowing quite a bit of time for
her forecast to be realized—almost two years. Jason, however, was looking
for short-term price appreciation. Concerns about time decay may have
been a motivation for Susanne to choose a long-term option—her theta of
0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the
theta of Jason’s May call will begin to rise sharply as expiration draws near.
But the trade-off of lower time decay is lower gamma. At the current
stock price, Susanne has a higher delta. If the XYZ stock price rises $2, the
gamma of the May call will cause Jason’s delta to creep higher than
Susanne’s. At $62, the delta for the May 60s would be about 0.78, whereas