LEAPS Option Strategies

The LEAPS Option Strategy Workshop is a collection of discussion pieces designed to assist individuals in learning how options work and in understanding various LEAPS options strategies. These discussions and materials are for educational purposes only and are not intended to provide investment advice.

Investment decisions should not be made based upon worksheet outcomes.

Access to, or delivery of a copy of, the Options Disclosure Document must accompany this worksheet.

Buying Index LEAPS Bull Call Spreads In Anticipation Of A Moderately Rising Market

Assume the YZX index is currently at 78. You are moderately bullish over the next couple of years. Unlike the 25 to 35 percent annual gain in the past two years, you expect relatively steady but slower-paced gains in the blue-chip average with only mild volatility along the way. You forecast the YZX index to gain somewhere between 15 to 20 percent over the next two years.

One strategy to explore for capitalizing on your forecast is to buy both an at-the-money LEAPS call and sell a higher-strike LEAPS call with the same expiration date. This strategy allows you to participate in the forecasted market gains while limiting your cost. A two-year 78.00 strike LEAPS call is trading at 10.125, and you buy five contracts for $5,062.50 (10.125 x 5 x $100 = $5,062.50). A two-year 93.00 strike LEAPS call (20 percent out-of-the-money) is trading at 4.50. You simultaneously sell five contracts and receive $2,250 (4.5 x 5 x $100 = $2,250). So your net outlay at the beginning of this strategy is $2,812.50 ($5,062.50 - $2,250 = $2,812.50). The table below shows your potential for profit and loss on the combined position at the end of the two-year period.

Outcome 1: The YZX index rose by 15 percent.
You were correct in your forecast. The YZX index rose by about 15 percent in two years to a settlement level of 89.70 at expiration. In this case, you exercise your long call position for a profit of $787.50 [(89.70 - 78.00 - 10.125) x 5 x $100 = $787.50]. Since the YZX index remained below the strike price on the short call, you keep the entire premium you received of $2,250. Your profit on the combined position is $3,037.50.

Outcome 2: The YZX index rose by 25 percent.
You underestimated the strength of the market. The YZX index rose by 25 percent to a settlement level of 97.50 at expiration. In this case, your long call position shows a profit of $4,687.50 [(97.50 - 78.00 - 10.125) x 5 x $100 = $4,687.50]. Since the YZX index rose above the strike price on the short call, your short call position offsets to zero profit/loss [(93.00 - 97.50 + 4.5) x 5 x $100 = $0]. Your profit on the combined position is $4,687.50. An important point here is that this is the maximum potential profit you could make on the total position. By selling an out-of-the-money LEAPS call, you no longer have unlimited participation and profit potential. Therefore, this strategy is most useful in periods of moderately rising markets.

Outcome 3: The YZX index remains at or below 78.
If the YZX index remains at or below the present level at expiration, you lose the entire amount of your investment, or $2,812.50. This is the maximum possible loss on the combined position for this outcome.

Buy Bull Call Spread - Summary

Possible outcomes of buying five LEAPS 78.00 calls and selling five LEAPS 93.00 calls
LEVEL OF YZX at expiration: 70.20 74.10 76.05 78.00 79.95 81.90 85.80
Move in the YZX index -25% -20% -15% 0% 15% 20% 25%
Profit/Loss: long call* (78 strike) -$5,062.50 -$5,062.50 -$5,062.50 -$5,062.50 $787.50 $2,737.50 $4,687.50
Profit/Loss: short call* (93 strike) $2,250.00 $2,250.00 $2,250.00 $2,250.00 $2,250.00 $1,950.00 $0.00
Profit/Loss: combined* -$2,812.50 -$2,812.50 -$2,812.50 -$2,812.50 $3,037.50 $4,687.50 $4,687.50
* Exclusive of commissions & taxes

Basics of bull call spreads
Profit & loss characteristics: The maximum loss is equal to the net cost of the spread and occurs if the long option expires out-of-the-money. The maximum gain on the position is equal to the difference between the spread's two strike prices minus the amount paid to establish the position. The maximum gain occurs when the short option is at-the-money or in-the-money at expiration.
Break-even point: At expiration, the break-even index level equals the lower strike price plus the spread cost (the cost incurred to establish the spread). A lower index level will incur losses, while a higher index level will show profits.
Time decay: Varies. The effect of time decay on a spread will vary depending upon strike prices and time remaining to expiration. The effect of time decay on a spread position is not usually too great, as it should affect both the purchased option and the sold option to some degree. In general, the passage of time more rapidly erodes the time-value portion of the premium of at-the-money and out-of-the-money options. This erosion will be more pronounced as the options near expiration. At expiration, the options' premiums will consist only of intrinsic value.
Volatility: The impact of change in volatility on spreads will vary depending upon strike prices and time remaining to expiration.

Commissions, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of option transactions and should be considered. The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security.