LEAPS is a synthetic rolling calendar?

[Tibster]

Is it safe to assume the LEAPS extrinsic value is the sum of expected extrinsic value of a monthly rolling position at the same strike until LEAPS date? My guts tell me it has to be, because if it's not, there's an arbitrage opportunity.

There's this fear of rapid decay of short term option, but I think it wrongly assumes the stock doesn't move. If the stock moves away from the strike, future months at that strike will require less premium to keep the position going. At the end of the LEAPS period, if the stock spent more time away from the strike, the sum will be less. If it didn't, the sum will be more. The average should be the LEAPS premium.

My reason for asking is I would be interested in a LEAPS position, but the spread is huge making it hard to get in and out easily. By using a rolling monthly position, I would benefit from higher liquidity for when I want to get out.

 

[Robert Morse]

Leaps are just long dated options. That simple. As there is more risk making assumptions on Interest, Dividends and Volatility going out up to 2 years, with no paper to trade against, the spreads are wider.

 

[beerntrading]

They're different positions with different exposures that will move differently given the same move on the underlying. It doesn't recreate a LEAP to just roll monthlies.

My reason for asking is I would be interested in a LEAPS position, but the spread is huge making it hard to get in and out easily. By using a rolling monthly position, I would benefit from higher liquidity for when I want to get out.

Quite a few flaws in your reasoning here. First, the Jan LEAP is usually the second most liquid expiry after the front month. Also remember that you will be paying monthly spreads 12 times through the year. And more importantly, your daily decay will be higher on the short-dated options than long dated.

I suspect your goal here is to gain exposure to intermediate - long term exposure to a stock, so I have a suggestion. Rest an order for the LEAP and wait for the price to come to you. Because it's long dated, you won't see a lot of movement in it the price relative to the underlying--which means you have a lot of time to wait inside the bid x ask for a fill. Instead of paying the spread, you'll receive most of it. Depending on your broker, you can also pick up the rebate for liquidity. Do that during a period of low volatility and you'll put your chances north of 50% on the position.

 

[Tibster]

Yeah I know that it's just an option, but there has to be a relationship to prior months. What I mean is if I were to buy a LEAPS or buy the front month and roll it every month, I would end up in the same situation, which is I would own an option at a given strike that expires.

AMZN example
Spot is 1685
Strike 1700 Calls
01/17/2020 = 276.35 / 281.60
06/15/2018 = 14.75 / 15.15
07/20/2018 = 45.25 / 45.95

Strike 1800 Calls
06/15/2018 = 0.53 / 0.64
07/20/2018 = 12.60 / 13.25

I could buy the 2020 call for 279 or so.
I could also buy the June call, then roll it 19 times. If spot is close to 1700, I would pay 30. If it moves 100 point away, I would pay 12.50. 200 points away would be closer to 3. Total cost of acquisition could be from 60 to 600.

I suspect your goal here is to gain exposure to intermediate - long term exposure to a stock, so I have a suggestion. Rest an order for the LEAP and wait for the price to come to you. Because it's long dated, you won't see a lot of movement in it the price relative to the underlying--which means you have a lot of time to wait inside the bid x ask for a fill. Instead of paying the spread, you'll receive most of it. Depending on your broker, you can also pick up the rebate for liquidity. Do that during a period of low volatility and you'll put your chances north of 50% on the position.

I'm playing with the idea of converting SPY stock into SPXU LEAPS puts during big red days and back into SPY after recovery. Getting in and out on time is a factor. The LEAPS is to give enough time for markets to recover or go volatile enough to grind the 3x inverse to nothingness. It's also used as a way to not overleverage since LEAPS on these are close to 30% of the spot price.

If the 2 methods are roughly equivalent, then I can use front month options + cash stack as a synthetic LEAPS position with the benefits of liquidity.

 

[ironchef]

I agree with beer, if you have an opinion on the underlying's long term direction, it is cheaper and more profitable to long LEAP. If you don't and just want to play volatility, then go short term based on your opinion of volatility and direction.

I am just a non professional retail option trader and a beginner so take my opinion with a grain of salt.

 

[Sig]

Is it safe to assume the LEAPS extrinsic value is the sum of expected extrinsic value of a monthly rolling position at the same strike until LEAPS date? My guts tell me it has to be, because if it's not, there's an arbitrage opportunity.

There's this fear of rapid decay of short term option, but I think it wrongly assumes the stock doesn't move. If the stock moves away from the strike, future months at that strike will require less premium to keep the position going. At the end of the LEAPS period, if the stock spent more time away from the strike, the sum will be less. If it didn't, the sum will be more. The average should be the LEAPS premium.

My reason for asking is I would be interested in a LEAPS position, but the spread is huge making it hard to get in and out easily. By using a rolling monthly position, I would benefit from higher liquidity for when I want to get out.

Short answer, no, even if you took out transaction costs and liquidity. Intuitively, think about it this way. The current optionality value of an option is based on it's currently IV. If you're speculating on options, you're really speculating on an IV mispricing, which implicitly means you think IV will change from it's current value during it's lifetime. If you buy a LEAP, you lock in that IV for the lifetime of the option. If you roll as you suggest, you're rebuying at another IV each time.
And for an even simpler explanation, if your option is about to expire worthless on your second monthly roll, how do you roll? You've got nothing to roll. If you had a LEAP, however, at that same strike, it would still have value.

 

[sle]

Simple math for an ATM option would tell you that it's not, even if you assume constant implied volatility. Let's say it's a 1 year leap and you have 12 1 month options. For ATMF, your premiums would roughly be:
1 year option = 0.4 * sqrt(1) * iv
1 month option = 0.4 * sqrt(1/12) * iv
So 12 times the 1 month option is more premium than the 1 year option.

PS. selling the short-dated options with a resetting strike is a basis for a very common portfolio insurance product (cliquet or ratchet options). The buyer of the product gets a long term put ("global floor") in exchange for selling forward starting OTM calls ("local caps").

 

[spindr0]

No, the extrinsic value of a LEAP is NOT the sum of expected extrinsic value of a monthly rolling position at the same strike. And no, there is no arbitrage opportunity because you aren't locking in a gain. However, there is the possibility of taking advantage of the
disparity in premium decay..

Time decay is non linear which means that shorter term expiries offer more premium per day than longer term expiries. That’s why writers tend to sell nearer weeks/months and buyers tend to buy further out weeks/months. A loose rule of thumb for demonstration is that the premium for an ATM option is related to the square root of the time remaining, with all other pricing parameters being equal.

So if a 9 month option is trading for $3 (sq rt of 9), it will be worth $2 at the 4 month mark (sq rt of 4) and $1 at the one month mark (sq rt of 1). IOW, it takes 5 months for the option to decay the first $1. It then takes 3 more months to lose the next $1 of premium and then only one month to lose the last $1 or premium. In reality, this isn't true across the board because there are several factors that affect the respective premiums (dividends, IV, B/A spread width, etc.).

Google and read about "Stock Replacement Strategy" and the "Poor Man's Covered Call".

The Stock Replacement Strategy is where you buy a deep ITM call LEAP (or a put if replicating short stock) as a replacement for long stock. If IV is sane, the time premium will be low. In return for modestly "overpaying" (the time premium), you control the same 100 shares while putting up only a portion of the total cost of buying the stock which means that you risk less should the underlying collapse. On an expiration basis, you can only lose the total premium but the share owner can lose more. If the underlying drops significantly prior to expiration but not to the strike, you will also lose less than the sharenowner because options retain value. You can model this or for a quick and easy evaluation, you can look at an option chain and guesstimate loss at various times and price.

The share owner receives dividends but the call LEAP owner does not. Since share price is reduced by the amount of the dividend on the ex-div date, the share owner isn't penalized as price drops artificially. The LEAP call owner receives nothing in return so he is penalized by the ex-div drop with a loss of intrinsic (time amount depends on the delta). Dividends are priced into the options and the amount is dependent on the strike but I want to keep it simple so let's leave it as you must factor dividends (into your comparison calculations.

Once you understand the Stock Replacement Strategy then it's a simple jump to using a deep ITM call LEAP as a substitute for stock in a covered call. This is a diagonal spread and also called the Poor Man's Covered Call.

The management of a PMCC is no different than a covered call since the long call LEAP is merely a surrogate for the long stock of a covered call. Since you pay some extrinsic for the call LEAP, you have to pay attention to not locking in a loss with your call sale - less done wittingly when a position is under water. The PMCC has an advantage over the CC in that if you are writing OTM calls against the call LEAP and the underlying moves up to that strike at expiration, you can roll the call LEAP up a strike, locking in some intrinsic gain. You won't get the full difference in strikes because LEAP spreads tend to be wide and unless you work the order and get a good fill, you'll take a haircut on the two B/A spreads of the roll.

The PMCC will take advantage of the disparate rates of time decay between the call LEAP and the shorter duration short term calls. In either case (stock Replacement or PMCC), you still have to be on the right side of direction to succeed.