Trading LEAPs: A Consistent Strategy
This article outlines a specific strategy for trading LEAP options, focusing on generating consistent income through selling puts. LEAPs, or Long-Term Equity Anticipation Securities, are option contracts with expiration dates typically a year or more away. This strategy aims to leverage the time value and higher premiums associated with LEAPs, while minimizing risk and maximizing return on capital.
What are LEAPs?
LEAP options are long-term option contracts that expire in a year or more. They provide traders the opportunity to take a longer-term view on the price movement of an asset. A key advantage is that LEAPs give traders more time to be right about their predictions.
Why Trade LEAPs?
Several factors make LEAPs an attractive trading instrument:
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Long-Term Opportunity: LEAPs offer an expiration period of one to three years, providing ample time for the underlying asset to move in the desired direction. This longer timeframe doesn't necessarily mean holding the trade for the entire duration.
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Higher Premiums: Due to their extended expiration, LEAPs command higher premiums than shorter-term options. This increased premium provides more flexibility and a wider margin for error.
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Further Out-of-the-Money: The higher premiums allow traders to sell puts further out-of-the-money and still receive good premium.
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Reduced Buying Power: LEAPs generally require less buying power compared to shorter-dated options, improving overall return on capital. When you look at buying power over the life of a LEAP, the daily cost is lower than short dated options.
Important Considerations
Before trading LEAPs, consider these points:
- Limited Liquidity: Some LEAP options, particularly for less popular stocks, may have lower trading volumes and less liquidity. This can result in wider bid-ask spreads, potentially impacting trading costs.
Core Philosophy: Option Selling and Income Generation
This strategy is built on the foundation of being an option seller and prioritizing income generation. The goal is to generate consistent income every month.
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Collecting Premiums: Selling options allows for the collection of premiums upfront, generating immediate income.
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Time Decay (Theta): Time decay works in favor of the option seller. As the expiration date approaches, the value of the option declines, and the seller retains the premium. By selling options, one is taking advantage of time decay working in their favor.
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Multiple Ways to Win: Option sellers can profit even if the stock price goes up, stays the same, or drops moderately.
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Higher Probability of Success: Selling out-of-the-money options has a higher probability of success because the underlying asset must move significantly to impact the position.
Two LEAP Strategies
Two LEAP strategies are employed. One is focused on in this article:
- Selling Leap Puts (Main Focus): Selling naked leap puts on specific underlines.
- Free Leap Call Spread: Involves buying calls and is a longer type of trade.
Strategy: Selling Leap Puts
Here's a breakdown of the strategy:
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Trade Risk and Sizing: Never risk more than 2% of your portfolio value on any one trade. Never allocate more than 30% of your available buying power to any one strategy.
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Underlying Assets:
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SPY (S\&P 500 ETF): The preferred underlying asset due to its diversification and tendency to appreciate over time.
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Top Growth Stocks: Consider large, stable companies like Apple and Microsoft.
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Select Assets: Identify assets coming off weekly oversold or support levels.
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Important Note: The goal is to avoid owning individual stocks. If assigned shares, the plan is to "wheel" out of the position as quickly as possible.
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Technical Analysis (TA): While not overly emphasized, TA can help identify potential entry points.
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Weekly Charts: Focus on weekly charts due to the longer-term nature of LEAPs.
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Indicators: Look for MACD and RSI rising from oversold conditions. Also look for weekly PSAR reversals.
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Daily Charts: Focus on anything coming off support or oversold.
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Trade Entry:
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Days to Expiration (DTE): Aim for approximately 365 DTE.
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Delta: Target a 12 Delta put (or 14 in higher volatility environments).
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Credit to Buying Power Ratio: Aim for a 25% to 30% credit relative to the buying power required for the trade. This translates to a 30-36% annual return if held for the entire year.
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Trade Management:
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Profit Target: Close the trade for a 30% profit.
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Stop Loss: Close losing trades at a 3X stop (2X max loss) or be willing to take assignment.
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Secondary Stop: Consider closing the trade at 21 DTE to avoid gamma risk, although taking assignment may still be an option.
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Specific SPY Strategy
A specific strategy involves adding one SPY leap trade every Monday, adjusting the number of contracts to maintain proper sizing. These positions are closed when they reach the 30% profit target. The strategy will be laddered up to 10 positions.
Backtesting and Results
Backtesting has shown promising results for this strategy:
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SPY: A backtest from January 2021 to June 2023, allocating 10% of a $100,000 portfolio, generated an annualized return of approximately 40%.
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Apple: A similar backtest with Apple yielded a 64% annualized return.
Real-world results have also been positive:
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Win Rate: A 97% win rate has been achieved.
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Average Days in Trade: The average trade duration is approximately 40 days.
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Average Return on Capital: The average return on capital per trade is approximately 7%, translating to a potential 64% annual return.
Conclusion
Selling leap puts, particularly on SPY, can be a viable strategy for generating consistent income, although it should be applied only to good companies. The strategy emphasizes careful risk management, a preference for income generation over speculative gains, and a willingness to take assignment under favorable conditions. While past results are not indicative of future performance, this strategy provides a framework for traders seeking to profit from the time value of LEAP options.
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