If you’re an options trader, you are familiar with the typical leverage of buying leap call options. This strategy offers a lower capital requirement compared to stock purchases and helps diversify your portfolio. Suppose you find a group of stocks with good price prospect growth over the year, and you don’t know whether to buy shares or calls. Our free backtest shows you what would have happened in the past.
Key takeaways
- Buying leap calls is a leveraged trade that can lead to higher profits compared to buying shares, and higher losses on the downside.
- With a lower capital requirement, you can increase the diversification of your portfolio, and the built-in stop loss of long calls helps you manage your risk.
- With our free backtest, you can see how a strategy of buying leap call options would have performed in the past for up to 5 tickers of your choice.
What Are Leap Call Options?
Let’s start by explaining the main features of leap call options in the table below:
Leap call options, or Long-Term Equity Anticipation Securities, are call options with expiration dates greater than one year. These extended expiration periods provide more time for the underlying stock to move in a favorable direction, making them a popular choice for traders looking for long-term opportunities.
How Leap Call Options Differ from Regular Call Options
Regular call options typically have expiration dates ranging from a few weeks to a few months. In contrast, leap call options can have expirations extending out two to three years. This longer time frame gives traders more flexibility and time for their investment thesis to play out. Additionally, trading leap call options requires less frequent management compared to shorter-term options. Add to that the fact that markets tend to move up, and you have an interesting position.
Leverage Trade Dynamics
Trading leap call options is essentially a leverage trade. Here’s why:
- More Upside Potential: If the stock price increases, the value of the leap call option can rise significantly, providing substantial gains.
- Downside Risk: Conversely, if the stock price falls, you can lose the entire premium paid for the option. However, this loss is limited to the initial capital invested, unlike holding the actual stock, which can result in larger monetary losses.
This built-in stop-loss feature means that while you can never lose more than 100% of your initial investment (which is a fraction of the full cost of 100 shares), you might gain multiples of that amount on the upside. Furthermore, since leap call options require less capital compared to buying shares outright, traders can diversify their portfolios more effectively.
Benefits of Trading Leap Call Options
- Longer Time Frame: Compared to other contracts, leap call options offer a longer duration for your investment thesis to materialize. This is particularly good for investments based on long-term trends or fundamental changes in a company.
- Less Capital Requirement: Because you are not purchasing the full stock but rather the right to buy it at a later date, the initial capital outlay is significantly lower. This lower requirement allows for better capital allocation across multiple trades.
- Stock Replacement Strategy: Leap call options can serve as a proxy for holding the actual stock. This method provides similar exposure to the stock’s price movement without the need for a large capital investment.
However, note that you don’t necessarily need to use leap options exclusively as a replacement for stock purchases. Shorter-term options with closer expiration dates are also available. Nevertheless, leap options best approximate the scenario of buying stocks because they provide a longer horizon, similar to how most investors do not anticipate selling their stocks within a few weeks. This is why we will focus on leap call options for the remainder of this content.
Our Idea: Trading Leap Call Options Can Lead to Higher Profits (If You’re Right)
We wanted to create a data-oriented study to prove the above points and learn about the application of this strategy. So, our idea begins with identifying a group of stocks that reputable analysts have marked as strong “Buys,” suggesting they would make a good portfolio for a long position. With these stocks, we consider two approaches: buying 100 shares or employing a long call strategy. For the options, we select calls that are at least 10% in-the-money (ITM) (such as those that you may find in our options screener) and set to expire in one year.
Profit Expectations
When trading leap call options, we anticipate either making a profit that is a multiple of what we’d earn through stock ownership or losing most of the capital invested in the option. In order to justify this strategy, it’s crucial to be correct more often than not. Essentially, most of the chosen stocks need to appreciate in value over the next year.
Example: Nvidia (NVDA) in 2023
Let’s illustrate this with Nvidia (NVDA), which experienced significant price growth in 2023. Suppose you purchased 100 shares of NVDA in January 2023. Alternatively, consider buying one 10% in-the-money call option that expires in January 2024. Here’s a backtest analysis comparing the results:
| Ticker | Stock Price Change % | Option Price Change % | $ P&L from Stock | $ P&L from Option |
| NVDA | 236.49% | 741.10% | $33,853.00 | $32,275.00 |
This table shows that while the percentage gain for the option is significantly higher than the stock, the dollar profits are comparable due to the leverage effect. When the underlying stock performs well, options can amplify your returns substantially.
Strategy Breakdown
Stock Selection:
- Choose stocks recommended by reputable analysts.
- Look for “Buy” ratings that indicate strong potential for price increases.
Investment Approach:
- Purchase 100 shares of each selected stock.
- Alternatively, buy long call options that are at least 10% ITM and set to expire in a year.
Risk and Reward:
- Expect to either make a high multiple of the profit compared to stock ownership or lose the entire invested capital in the option.
- The key to this strategy is being right about stock price movements most of the time.
Backtesting Long Calls from a List of Stock Recommendations for 2023
We start by considering the 2023 stock recommendations from Edward D. Jones & Co., L.P. (link at the end of the article) For our backtest, we exclude two categories of stocks:
- Stocks without Listed Options: Stocks that did not have any listed options expiring at the beginning of 2024.
- Stocks with Price Splits: Stocks that underwent a price split in 2023. A split replaces pre-split options with post-split ones, making them technically different contracts. For simplicity, we stick to options that remain the same contract throughout the year.
Backtesting Method
In January 2023, we take these remaining 49 tickers and compare two strategies:
- Buying 100 shares of each company.
- Buying a long call option expiring at the beginning of 2024 (at least 10% in the money).
Here is a complete table with the results we obtained:
| Ticker | Stock price change % | Option price change % | $ P&L from stock | $ P&L from option |
| GOOGL | 55.04% | 188.86% | $4905.00 | $3864.00 |
| CMCSA | 22.77% | 90.12% | $810.00 | $666.00 |
| DIS | 1.96% | -44.36% | $174.00 | $-896.00 |
| AMZN | 74.70% | 255.46% | $6411.00 | $5283.00 |
| LOW | 9.85% | -6.40% | $1961.00 | $-323.00 |
| ROST | 18.86% | 15.75% | $2185.00 | $415.00 |
| TPR | -1.70% | -41.60% | $-66.00 | $-406.00 |
| ULTA | 3.18% | -33.72% | $1498.00 | $-3623.00 |
| EL | -42.72% | -99.83% | $-10846.00 | $-5875.00 |
| MDLZ | 11.46% | 8.39% | $759.00 | $113.00 |
| PEP | -3.62% | -57.17% | $-650.00 | $-1754.00 |
| PG | -1.87% | -42.20% | $-283.00 | $-1015.00 |
| CVX | -14.09% | -97.62% | $-2451.00 | $-3657.00 |
| MPC | 37.36% | 51.18% | $4144.00 | $1520.00 |
| TTE | 9.98% | 24.27% | $613.00 | $250.00 |
| BRK.B | 16.96% | 47.48% | $5255.00 | $2989.00 |
| ALL | 5.23% | 16.95% | $715.00 | $300.00 |
| BAC | 1.16% | -39.91% | $39.00 | $-269.00 |
| BLK | 12.40% | 14.04% | $8826.00 | $2025.00 |
| COF | 42.10% | 25.86% | $3914.00 | $565.00 |
| JPM | 27.35% | 107.30% | $3696.00 | $2676.00 |
| TFC | -14.03% | -91.73% | $-612.00 | $-1165.00 |
| AMT | 1.93% | -37.12% | $414.00 | $-1544.00 |
| O | -8.20% | -65.77% | $-523.00 | $-730.00 |
| ABT | 0.25% | -29.71% | $27.00 | $-655.00 |
| DHR | -10.48% | -86.67% | $-2748.00 | $-5123.00 |
| JNJ | -10.23% | -91.56% | $-1822.00 | $-2463.00 |
| MDT | 5.85% | 0.37% | $458.00 | $5.00 |
| MRK | 1.89% | -24.58% | $210.00 | $-440.00 |
| PFE | -42.00% | -99.90% | $-2153.00 | $-964.00 |
| TMO | -1.63% | -50.32% | $-903.00 | $-4831.00 |
| UNH | 3.99% | -31.71% | $2070.00 | $-3171.00 |
| ZTS | 33.86% | 149.88% | $4972.00 | $3161.00 |
| DE | -5.51% | -77.50% | $-2338.00 | $-7699.00 |
| RTX | -15.46% | -98.88% | $-1559.00 | $-1854.00 |
| LUV | -12.64% | -83.20% | $-412.00 | $-738.00 |
| UNP | 17.27% | 57.44% | $3585.00 | $2235.00 |
| LIN | 28.66% | 33.15% | $9123.00 | $2365.00 |
| AAPL | 48.43% | 160.09% | $6057.00 | $4665.00 |
| MSFT | 54.80% | 225.60% | $13129.00 | $11190.00 |
| NVDA | 236.49% | 741.10% | $33853.00 | $32275.00 |
| AVGO | 96.10% | 467.59% | $53190.00 | $54067.00 |
| IBM | 14.09% | 53.38% | $1995.00 | $1265.00 |
| PYPL | -17.59% | -96.67% | $-1312.00 | $-2064.00 |
| CRM | 90.04% | 299.64% | $12135.00 | $9888.00 |
| NOW | 78.35% | 184.24% | $30202.00 | $22330.00 |
| V | 24.82% | 77.55% | $5148.00 | $3203.00 |
| DUK | -5.68% | -58.76% | $-589.00 | $-812.00 |
| NEE | -26.55% | -99.94% | $-2226.00 | $-1627.00 |
| Total | 18.49% | 34.18% | $335815.00 | $113617.00 |
In the subsections below, we will focus on three specific cases to illustrate the results.
Case 1: Alphabet Inc. (GOOGL)
- Stock Performance: The stock price increased by 55.04%.
- Option Performance: The option’s price rose by 188.86%.
This is a typical scenario where trading leap call options yields significantly higher returns compared to owning the stock. If you had bought 100 shares of GOOGL at the beginning of 2023, your profit would be substantial, but the return on the long call option is more than triple the stock’s performance due to the leverage effect.
Case 2: Estée Lauder Companies Inc. (EL)
- Stock Performance: The stock price decreased by 42.72%.
- Option Performance: The option’s price plummeted by 99.83%.
This case shows the extreme downside risk. The significant drop in EL’s stock price pushed the initially in-the-money call option out of the money, almost completely wiping out the investment. This illustrates the maximum risk associated with trading leap call options when the stock performs poorly.
Case 3: The Walt Disney Company (DIS)
- Stock Performance: The stock price increased by only 1.96%.
- Option Performance: The option’s price decreased by 44.36%.
This is the main risk linked to this strategy: a stock price may move up, but not high enough to give you a profit with the option you bought (in fact, you may lose your money in these cases). Here, the small increase in stock price was insufficient to justify the option investment. The call option lost a large part of its extrinsic value, demonstrating the classic risk of buying call options instead of shares. Even though the stock didn’t decline, the minimal gain led to a significant loss in the option’s value.
After seeing these 3 cases, here are the main points of what we discovered:
- Higher Potential Returns: Trading leap call options can generate significantly higher returns than stock purchases if the stock performs well, as shown in the GOOGL example.
- High Downside Risk: Significant stock declines can result in almost total losses for call options, highlighted by the EL example.
- Risk of Underperformance: Small gains in stock prices may lead to losses in option investments, evident in the DIS case.
If you take a look at the table above, you’ll see that, even though some trades ended up being completely wrong, we would have ultimately earned money on this stock and options portfolio. The difference here is that the capital required for the options portfolio would have been significantly lower compared to the stock purchase operation.
Practical Considerations
When trading leap call options, it’s essential to:
- Select Stocks Carefully: Choose stocks with strong growth potential based on sound research and recommendations from reputable analysts.
- Understand Risks: Be aware that while the upside is magnified, so is the downside. You can lose your entire investment if the stock performs poorly.
- Diversify: Use the lower capital requirement of options to diversify your portfolio across multiple positions to manage risk better.
By understanding these dynamics and carefully selecting your trades, you can leverage the power of trading leap call options to potentially achieve higher profits, provided your stock picks perform well.
Using Our Backtest File
Having seen all these results, let us show you how you can run your own analysis using our backtest file. This tool allows you to replicate the same type of analysis by using historical options data. You can add up to 5 tickers to the analysis and use data from past years to perform the backtest.
Step-by-Step Guide to Using Our Backtest File
Begin by creating your own copy of our backtest file on Google Colab (just go to “File” and then create a copy for yourself). Next, follow these simple steps to run your analysis.
Step 1: Identify Up to 5 Stocks
Start by selecting up to five stocks on which you would have been bullish in the past. Consider stocks you were optimistic about based on market trends, reputable analyst recommendations, or personal insights. The idea is to choose stocks that align with your investment strategy and have shown potential for growth:
Step 2: Enter the Tickers and Select a Year for Analysis
Once you have your list of stocks, enter the tickers into the backtest file. After entering the tickers, select a specific year for the analysis:
This will allow the tool to pull historical options data for that year, giving you a clear picture of how trading leap call options could have performed. To run the code, just go to the “Runtime” menu at the top and run the whole script.
Step 3: Understanding the Analysis Results
The backtest file provides a detailed table with the following fields:
- Ticker: The ticker symbol of the stock you added to the analysis.
- Stock Price Change %: The percentage change in the stock price over the selected year.
- Option Price Change %: The percentage change in the price of the leap call option you would have bought.
- $ P&L from Stock: The USD profit (or loss) you would have obtained from the stock trade.
- $ P&L from Option: The USD profit (or loss) you would have obtained from the call trade.
Here’s an example of what the table might look like:
This table helps you compare the performance of purchasing shares versus trading leap call options for each stock.
Step 4: Analyze and Decide
With the results in hand, you can evaluate whether buying calls instead of shares would have been a good idea based on historical performance. While past performance is not a perfect indicator of future results, it can provide valuable insights into the potential risks and rewards associated with trading leap call options.
Understanding the Backtest Methodology (and Its Limitations)
Last but not least, you should understand the backtest methodology and its limitations when trading leap call options. While backtesting can provide valuable insights, it is not a guarantee of future performance. The market is unpredictable, and various factors can affect stock prices, including economic changes, company-specific news, and broader market trends.
How Our Backtest Works
Our backtest uses historical options data to simulate potential profits or losses. Here’s a brief breakdown of the process:
- Historical Data: We pull historical data for both stocks and their corresponding leap call options. Just like we did in our study above, we’ll focus on the first trading day of each year.
- Simulation: The backtest simulates trades by calculating the percentage change in stock prices and the corresponding change in the option prices over a selected period.
- Profit/Loss Calculation: It then calculates the USD profit (or loss) for both the stock and the option trades, allowing you to compare the results side by side. What will happen here is that the script will compare the option purchase price at the beginning of year 1 to the price of the same contract on the first trading day of the next year. Note that, in this case, the option will be close to expiration, but not expired yet. We built the system in this way in order to simulate the case in which you would have simply sold your call option before expiration to earn a profit (or take a loss).
By running these simulations, you get a clearer picture of how trading leap call options might perform under similar conditions in the future.
Key Points to Remember
- Excluded Stocks: Just like we did in our research, the script does not take into account stocks that did not have any listed options expiring at the beginning of the following year. For simplicity, we also removed stocks that underwent a price split during a year, like we did in the study above.
- Market Unpredictability: Backtested results assume consistent market conditions, which is rarely the case. Economic events, political decisions, and unforeseen circumstances can significantly impact market performance.
- Historical Limitations: Historical performance data may not account for all variables that could influence future outcomes.
- Data Integrity: Ensure the historical data used is accurate and comprehensive to get reliable backtest results.
Practical Use
To make the most out of backtesting:
- Diversify: Test multiple stocks to spread risk and avoid heavy reliance on a single stock’s performance.
- Regular Review: Consistently update your backtests with the most recent data to adapt to current market conditions.
- Complementary Tools: Use backtesting alongside other analysis tools and strategies to form a well-rounded investment approach.
While backtesting trading leap call options provides useful insights, remember that it’s just one tool in your trading toolkit. Make informed decisions and remain adaptable to market changes for better investment outcomes.
To quickly access all the resources you need, we added a few links below:
