Introduction
Hey there! Many of you know that I've been really into leaps lately. They're all I can talk about and think about. I absolutely love them. If I could marry them, I would, but unfortunately, I can't (although I haven't actually checked). While leaps are great, some of you have raised concerns that they're not suitable for everyone. The main issue is the cost. Leaps on stocks like Microsoft or Apple can cost three, four, or even five grand. Some people might be able to afford them, but it could lead to over - allocating funds to leaps in their portfolio, throwing the whole thing out of balance due to excessive leverage. So, I'm here to offer some solutions if you're facing this problem and want to participate in the market but can't afford leaps.
Solution 1: Build Your Nest Egg
Consider Long-Term Investing
The first solution might not seem like a solution at all, but it's worth considering. If you can't afford leaps, this could be a great time to start building up your savings. Add money to long-term investments. Once you've accumulated enough funds, you can then consider buying leaps as a form of leverage. When you have a substantial nest egg, you won't be as worried about the success or failure of individual trades because you already have money earning compounding interest. Long-term investing is often underappreciated in our circle, but it can be a solid foundation for your financial future.
Solution 2: Adjust Your Strike and Delta
Raise Your Strike
If you're set on using leaps but can't afford the typical ones, another option is to raise your strike. This will result in a lower delta compared to the usual 0.7 - 0.9 delta leaps. Yes, it will increase your break-even point and reduce the probability of success. However, if raising the strike doesn't significantly impact your potential and makes the leaps affordable, it might be a viable choice. Lowering the delta to around 0.65 or 0.6 will reduce your chances of success, increase theta (time decay), and raise your break-even. The stock price will need to rise further over time for you to reach the break-even point. But if you have a very bullish outlook on a stock and think you've bought a great dip, it could be worth it. Just make sure not to over - allocate to these call options.
Shorten the Time Until Expiration
You can also shorten the time until expiration to make the leaps cheaper. But this comes with its own risks. You'll be under more pressure to see the stock price move in your favor quickly, like trying to beat the buzzer. Additionally, if you sell for a profit within a year, you'll be taxed at the higher short-term capital gains tax rate instead of the lower long-term capital gains tax rate, which you'd get if you held the position for at least a year and a day.
Solution 3: Try Debit Call Spreads
What is a Debit Call Spread?
The main solution I want to offer today is to try debit call spreads. A debit call spread involves buying a long call option and then selling a call option against it. This results in a lower break-even point because you receive a credit from selling the call option, which reduces the cost of the trade and the amount of buying power needed. When you buy a long call, it's a debit (you pay money), but when you sell to open a call option, you receive money. Overall, this reduces the buying power required, making the trade cheaper.
Pros and Cons of Debit Call Spreads
Potential Profits are Capped
One of the main drawbacks of debit call spreads is that your potential profits are capped. As the stock price rises and pushes your spread in the money, your long leg makes money, but your short leg loses money. Initially, your long leg makes more than your short leg loses, but at a certain point, their deltas become similar, and they start to negate each other. This means you'll reach a maximum potential profit.
Limited Downside
On the flip side, if the trade goes against you and the spread moves out of the money, your downside is limited. This is significantly better than if you just bought a call option outright. It reduces your max profit but also your max losses, shrinking the stock price range within which you'll make or lose money.
Tax Implications
Another consideration is the tax implications. Since your potential profits are capped, you're likely to reach your max profit and need to sell the position earlier, often within a year. This means you'll be taxed at the short-term capital gains tax rate, which is not as favorable as the long-term rate.
Example of a Debit Call Spread on Microsoft
Setting Up the Spread
Let's say we want to open a spread on Microsoft. We start with the long leg, the call option we're going to buy. We select an option with an expiration date about a year out to give the stock time to move up and potentially hold the position for longer than a year to be taxed at the long-term capital gains tax rate. With debit call spreads, you don't have to buy the long leg as deep in the money as you would with leaps. Liquidity is crucial, especially with two - leg spreads. We'll aim for a 0.6 - 0.65 delta. For Microsoft on June 17th, 2022, a 0.6 delta corresponds to a 240 strike.
Adding the Short Leg
Next, we create the short leg by writing a call option. We choose the same expiration date. The further out of the money the short call option is, the more expensive the trade will be, with a larger max loss but also a larger potential profit. We manipulate the short leg to make the overall trade cost what we want. For example, if the long leg costs $3,300 and we want to reduce the overall cost to $2,000, we can sell a call option that gives us a credit of about $1,300, like the 290 strike.
Analyzing the Spread
The cost of the trade is now $2,000, which is the max risk. Our max return is about $3,000, and our breakeven at expiry is 260.30. If you want to lower the breakeven, you can lower the short strike. Keep in mind that the short strike is where you expect the stock price to be by expiration if you want to hit max profit.
Assignment Risk with Debit Call Spreads
Before Expiration
When you sell to open an option (write an option), you expose yourself to assignment risk. Before expiration, if your short leg becomes in the money, your counterparty may exercise it. If they do, they'll buy 100 shares at the strike price, and you'll have to sell 100 shares to them. If you don't already own the shares, you'll end up with a short position of - 100 shares. You'll still have your long call, and in this case, you should close both positions. This will result in a profit.
At Expiration
At expiration, if you get assigned, you'll end up with a short stock position of - 100 shares. Your brokerage will automatically exercise your long call, buying 100 shares. This will result in a flat position, and you'll have your max profit.
Pin Risk and Dividends
If the stock price is close to the strikes of your options at expiration, close the position before expiration to avoid pin risk. Also, if an upcoming dividend is larger than the extrinsic value of the option, your counterparty is likely to exercise, and you'll be assigned.
Trading a Debit Call Spread Example
Using Thinkorswim's On-Demand Feature
We'll use Thinkorswim's on-demand feature to simulate a trade. We're on January 2nd, 2020, and we want to open a debit call spread on Microsoft with an expiration on January 21st, 2022. We start with the long leg at a 0.65 delta, a 145 strike. We right-click and select "buy and vertical" to create the spread. Then we choose the short leg, like the 185 strike, to get the desired cost and risk for the trade.
Monitoring and Closing the Trade
We set the order as a limit order and start at the mid price. If we don't get a fill, we can adjust the price. When monitoring the trade, we're concerned about the overall profit loss, not the individual profit loss of each option. If the trade is doing well, we can close it by right-clicking and selecting "create closing order."
Conclusion
In conclusion, if you can't afford leaps, there are alternative ways to leverage your portfolio. Building your nest egg through long-term investing, adjusting your strike and delta, or using debit call spreads are all viable options. Each has its pros and cons, so it's important to choose the strategy that works best for your financial situation and risk tolerance. Thanks for watching, and best of luck with your trading! Don't forget to check out the links in the description for more information and tools.
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