Options trading may seem like it’s riskier than buying stock but selling LEAPs can actually reduce the overall risk in a position.
If you’re interested in LEAPs investing and options trading, you may have already read our post about using LEAPs calls as a substitute for buying a stock. That article highlighted several of the benefits of investing in LEAPs for conservative investors, including position scaling and loss limiting, but one conservative strategy it didn’t touch on was selling LEAPs as an alternative to setting a long-term buy limit on a stock or ETF you’re interested in buying.
On first impression, it may seem like introducing options and LEAPs trading into a conservative investment strategy would increase the risk but that’s not actually the case. While selling LEAPs does add a little complexity to the trade, the right trade can actually be less risky than simply buying a stock.
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To better understand how a conservative investor can use selling LEAPs to potentially enter into a stock position, let’s break down several scenarios using Nvidia (NVDA), a high-flying stock that’s up 60% YTD.
3 Strategies to Use Selling LEAPs to Buy Stock
As a refresher, keep in mind that a LEAPs contract represents 100 shares, and will generally require that you maintain the purchase price of those shares in cash (unless you’re selling naked puts, which is a complicated high-risk strategy that’s not appropriate for conservative investors). As of this writing, buying 100 shares of NVDA would cost you roughly $20,900.
If you purchase the shares you have unlimited potential gains, and your maximum loss is $20,900 (unlimited gains are merely hypothetical as a stock can only trade so high). What if you wanted to change the dynamic of the trade and potentially reduce your purchase price in exchange for limiting your potential gains? Selling LEAPs can help you do that, and the best way to implement that trade depends on your goals and expectations for NVDA. We’ll use three strike prices at round numbers as they tend to attract higher volume, which translates to better liquidity and narrower differences between the bid and ask (the spread).
Out-of-the-money puts – First, let’s look at out-of-the-money contracts. If you’re selling LEAPs, out-of-the-money puts means that the contract strike price is below the current market value. For our example, we’ll look at a 180 strike price. The 180 strike with a January 2023 expiration is trading for roughly 22. Selling that contract would net you $2,200 in premium and tie up $18,000 (the strike price x 100 shares).
Why make that trade? If you believe NVDA is overvalued but would be interested in buying it at 180, selling LEAPs allows you to imitate a long-term buy limit order. Plus, the premium you receive reduces your effective buy price to 158 (180 strike less 22 premium received). If the shares trade below the strike at expiration, your contract will be executed at $18,000 regardless of where the shares are. This trade is a losing proposition if the shares close below your effective buy price of 158 but it’s profitable at any price above that, and the premium represents a roughly 12% return if the contract expires worthless.
At-the-money puts – Selling LEAPs at-the-money means using a strike price that is near the current share price—we’ll use 205 for our example. The 205 strike with the same expiration is currently trading at about 34. Selling that contract would net you $3,400 in premium and tie up $20,500.
Why make that trade? If you believe NVDA is fairly valued but believe it could trade slightly lower at expiration and want to reduce your purchase price. In the event NVDA is trading below 205 at expiration, this contract would be exercised, and you would own NVDA at 171 per share (205 strike less 34 premium received), which is your breakeven price for determining profit or loss. In the event that NVDA continues to trade above the 205 strike price, the contract would expire worthless and you will have generated roughly 16.5% in premium.
In-the-money puts – Selling LEAPs in-the-money means using a strike price above the current share price, which could be exercised at any time. The 225 strike (again, round numbers tend to equal greater liquidity) put with the January 2023 expiration is currently trading at 45.
Why make that trade? If you believe NVDA is currently undervalued and are comfortable buying it up to a net price of 180 (225 strike less 45 premium). That net price is your breakeven if the contract is exercised, which is higher than the other scenarios but still a discount to the current share price. Should NVDA trade higher and close above 225 you will have generated a return of 20%, which is more than you would have made buying the stock at 209 and watching it move to 225.
Selling LEAPs puts requires that you be overall bullish on the underlying stock and have a specific fair value in mind. Your worst case for all of these scenarios would be NVDA becoming worthless, which is no different than the worst case for simply buying the stock. But, by selling LEAPs, you’re generating returns that actually reduce your overall position risk because of the premium received.
Have you used selling LEAPs to enter into a new stock position?
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