Papale on LEAPs

By Steve Papale

Last March Baltimore Raven’s lineman John Urschel co authored an academic article titled, “A Cascadic Multigrid Algorithm for Computing the Fiedler Vector of Graph Laplacians” in the Journal of Computational Mathematics.  Wonder how he did on his Wonderlic test?

LEAPS or Long Term Equity Participation Securities are nothing more than options that have expirations going out to 3 years.  We have talked about this in the past but I have had some questions on this recently so I decided to revisit the subject.

The same strategies can be used for LEAPS as any other option in theory however since there is so much time in these options a few things should be mentioned.  With the greater time to expiration, the extrinsic or time value is higher.  This greater extrinsic value means a greater vega and consequently greater exposure to changes in implied volatility.

So while a 1% change in implied volatility will have a greater impact on a 2 year option than a 3 month option, in fact the farther in time we go out, the less there is of what we call “volatility of volatility”.  All that simply means is any given change in implied volatility tends to be dampened as we go out in time.  The 2 year option IV moves less than the 3 month option IV.

Another thing to remember is changes in interest rates have a greater impact on longer term options than shorter term.  If you are financing a position for 3 years vs. one month, your much more rate sensitive on the LEAP than the short term option.  Finally, dividend changes will have a magnified impact on LEAPS compared to short term options.  Since the price of stock is made up of present value of future dividends, any change in the dividend stream will have a greater impact the longer the dividend stream affected.

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