The markets have recently experienced periods of low Implied Volatility (IV). A popular low IV strategy touted on trading blogs is to purchase LEAPs (options that expire past 1 year) in such an environment. Here at tastylive, we don’t agree. So why don’t we think this is a profitable strategy?
Our first reason is that although IV may be low when you buy a LEAP, the further out months will have a higher IV. The vast majority of the time volatility is in Contango. A table provided the figure demonstrating this point. You are paying a premium for the further out options. A graph compared a 2018 LEAP option with a 21% IV to a November 2016 option with an 11% IV. The graph demonstrated that you paying significantly more in extrinsic than you may think and the option is costing 10% of the underlying value.
Our second reason for disliking the LEAP buying strategy is that IV tends to be mean reverting. A table of a June 2017 option, January 2018 option and December 2018 option was displayed. The table included the current IV and the percentage of days that the IV is above the current IV was displayed. The table showed that buying LEAPs tend to lock in losses because on average the percentage of days that IV is above is around 15%. Tom explained, “15% of the time IV is going to expand and 85% of the time IV is going to contract. So 85% of the time you are fighting the devil.”
Our third reason is that LEAPs are less sensitive to moves in the stock and to spikes in implied volatility. An example comparing an 8% down move in the SPY in January 2016 was displayed. The example showed that the SPY February 2016’s option’s IV increased from 20 - 28 but the SPY January 2017 LEAP option’s IV only increased from 23-25 in the same time frame. The example showed that LEAPs “can be misleading” to traders that believe they are going to capture rises in the underlying’s IV.
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the important takeaways and our compelling reasons, backed by hard data, that explain why buying LEAP options is a poor trading strategy.
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