Using LEAPS in Diagonal Spreads for Long-Term Positions

The use of Long-Term Equity Anticipation Securities (LEAPS) as the long leg of a diagonal spread is a popular strategy among long-term options traders. LEAPS, which are options with expiration dates of one year or more, provide a capital-efficient way to gain long-term exposure to a stock. By combining a long LEAPS call with a series of short-term calls, traders can create a Poor Man's Covered Call that can be managed for months or even years.

What are LEAPS and Why Use Them in Diagonal Spreads?

LEAPS are simply options with very long-term expiration dates. They behave much like the underlying stock, but with a much lower capital outlay. This makes them an ideal substitute for owning stock in a covered call strategy. The primary advantage of using LEAPS in a diagonal spread is the reduced time decay. Because the LEAPS call has so much time until expiration, its theta is very low. This means that the long call will lose very little value to time decay, while the short-term call will decay rapidly.

The Benefits of Using LEAPS

The most significant benefit of using LEAPS in a diagonal spread is the capital efficiency. A trader can control 100 shares of a high-priced stock for a fraction of the cost of buying the shares outright. This can lead to a much higher return on capital. Another benefit is the reduced time decay. The low theta of the LEAPS call means that the position is less sensitive to the passage of time.

The Drawbacks

While there are many benefits to using LEAPS, there are also some drawbacks. The most obvious is the higher capital requirement compared to a traditional diagonal spread. Because LEAPS are more expensive than shorter-term options, the initial outlay will be greater. Another drawback is the lower liquidity. LEAPS are not as actively traded as shorter-term options, so the bid-ask spreads can be wider.

How to Select the Right LEAPS

When selecting a LEAPS call for a diagonal spread, the most important factor to consider is the delta. The delta should be high, ideally 0.80 or greater, to ensure that the option behaves like the underlying stock. The expiration date should be at least one year out to minimize the effects of time decay. The strike price should be in-the-money to achieve the desired high delta.

Managing a LEAPS Diagonal Spread

Managing a LEAPS diagonal spread is very similar to managing a traditional diagonal spread. The primary task is to roll the short call on a monthly basis. As the short call approaches expiration, the trader must decide whether to close it, roll it, or let it expire. The goal is to continuously generate income from the short calls while the long LEAPS call appreciates in value.

Comparing LEAPS Diagonals to Traditional Diagonals

The main difference between a LEAPS diagonal and a traditional diagonal is the time horizon. A LEAPS diagonal is a long-term strategy that can be held for a year or more. A traditional diagonal is a shorter-term strategy that is typically held for a few months. The choice between the two depends on the trader's time horizon and capital commitment.

By understanding the advantages and disadvantages of using LEAPS in diagonal spreads, traders can make an informed decision about whether this strategy is right for them. For those with a long-term bullish outlook on a stock, the LEAPS diagonal can be a effective and capital-efficient way to generate consistent returns.