If you’re a long premium trader, or have been considering deploying such positions due to recent lows in VIX, you may have been considering longer-dated expirations - in order to give them more time to “work.”
While that may be a sensible approach, and might fit your portfolio perfectly, a new episode of Best Practices presents new research which may help with your decision-making process.
LEAPS, or Long-Term Equity Anticipation Securities, are somewhat unique in the world of options as they offer expiration dates greater than one year from the date of trade deployment.
LEAPS are easy to differentiate from other options because their expiration dates typically have the next calendar year (or even the one after that) listed in the expiration date. For example 1/17/20 is the expiration date of LEAPS maturing in January of 2020.
Technically speaking, there aren't any further differences between LEAPS and other standard, exchange-listed option contracts. From a strategic perspective, however, there are of course many important nuances that differentiate LEAPS from shorter-dated options.
On Best Practices, the hosts provide further details on LEAPS, as well as fresh tastytrade research that helps illustrate the “extra” premium inherent in LEAPS - a feature that usually isn’t viewed as desirable when buying options.
But first, let’s take a look at implied volatility across the time horizon of expirations in SPY - including 2019 and 2020:
As you can see in the chart above, implied volatility in SPY increases significantly as you go further out on the time horizon. On the surface, this makes sense, as longer-dated periods theoretically possess more uncertainty as compared to options that expire next week, or next month.
For example, we can be relatively certain the Earth won’t be wiped off the face of the universe by a giant asteroid in November 2018. But looking out to 2020, our confidence diminishes, even if only by the smallest of margins.
The same can be said for activity in the financial markets - it’s simply a lot harder to predict what kind of trading environment we’ll find ourselves in when 2020 rolls around - which is why premiums are inflated to account for that.
In our analysis of LEAPS, we can also look at historical data and see how often actual volatility has been higher than implied volatility. According to tastytrade research, actual volatility rose above implied volatility less than 50% of the time (on average), according to the date below:
July 2019: 40%
January 2020: 35%
December 2020: 30%
Taken together, this information tells us that LEAPS premium is usually priced to compensate for added uncertainty (i.e. more premium), and that actual volatility doesn’t often trade above implied volatility. Certainly not the attributes one usually puts at the top of their wish list when looking for “cheap” long volatility opportunities.
A natural question you may be asking right now is whether LEAPS might be a good candidates for the opposite type of trade - short premium trading opportunities.
Fortunately, this precise topic was covered on a previous installment of Strategies For Your IRA, and we think the information presented on this episode is also worth a few moments of your time.
While the hosts of the show discuss short LEAPS comprehensively, we’ll at least your provide you with a sneak-peek here. First, one must consider that when LEAPS do get traded, the liquidity isn’t typically robust enough to earn a place on our radar.
Likewise, the prospect of trading options with such long durations means that capital in our accounts gets tied up for a longer period of time. That reduces our available capital, and in turn our ability to increase occurrences - two more negatives.
For a complete rundown on LEAPS (long or short), we hope you’ll take the time to review the complete episodes of Best Practices (long LEAPS) and Strategies For Your IRA (short LEAPS) when your schedule allows.
If you have any questions about LEAPS, or any other trading topic, we hope you’ll leave a message in the space below, or contact us at @tastytrade on Twitter or by email at email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.