What Are Leaps Options?

Long-Term Equity Anticipation Securities (LEAPS).

Long term equity anticipation securities (LEAPS) are publicly traded options contracts that have an expiration length of more than one year, generally up to three years from the date of issue. They are functionally equivalent to most other alternatives mentioned but with extended expiry dates. A LEAPS contract gives a buyer the right, but not the responsibility, to buy or sell the underlying asset at a preset price on or before the expiry date.

LEAPS are similar to single-leg calls and put but with substantially longer maturities. Buyers can exercise an option before it expires, but they are not obligated. If allocated the options position, sellers are bound by the contract's terms. LEAPS are comparable to having a long-term stock investment in many aspects but with substantially reduced risk and capital allocation. LEAPS techniques are similar to short-term options strategies, but because of the slower rate of time decay, they often favor purchasing tactics over selling methods. LEAPS may have American or European-style expirations and are bought and traded like its short-term equivalents. LEAPS may be used with other options methods to define risk, hedge a position, or lower the cost basis of the LEAPS contract.

Outlook for LEAPS

LEAPS are similar to short term options, but they have a considerably longer time horizon. Individually, they may be used to produce income, speculate on future price movement, or hedge against risk in other options or stock holdings. To develop multi-leg strategies, LEAPS may be paired with other option contracts. The main advantage of employing LEAPS options is the lower cash outlay necessary to initiate a position than owning or shorting shares during the same period. Furthermore, the adverse risk is clearly defined and restricted to the premium paid at entry.

For example, if an investor sought to buy 100 shares of a $100 stock, the initial money necessary to start the transaction would be $10,000, which would be at risk if the underlying asset dropped to $0. A LEAPS call option would provide similar exposure for a fraction of the cost. LEAPS may also be sold to earn money. They may be used with stock to hedge a position or short or long-term options contracts to build cost-effective and risk-defined strategies. In techniques that combine stock ownership with quick options contracts, such as covered call writing, LEAPS are employed instead of equity shares.

Setup for LEAPS

LEAPS are started in the same way as any other option contract. By picking a contract from the options chain, an investor may buy-to-open (BTO) or sell to open (STO) a position. The primary distinction is that a LEAPS contract must have an expiry date at least one year away. Because the options will have considerable extrinsic value, the longer the period to maturity, the higher the cost.

Because the option's value is more susceptible to variations in implied volatility, interest rates, and price movements of the underlying stock, the Greeks (Delta, Gamma, Vega, Theta, Rho) play a big part in its pricing.

Payoff Diagram for LEAPS

The payout diagram for buying a single-leg LEAPS contract will look like a long call or long put option, with the same profit and loss possibilities. The risk is restricted to the initial deposit, but the profit potential is limitless. Because of the extended period to expiry, the cost of entering a long LEAPS contract will be substantially greater than shorter-term options. The breakeven points will be significantly farther away from the strike price due to this. The arithmetic stays the same: the stock price must be higher than the strike price plus the debit paid to be profitable.

If a long call option with a strike price of $100 is bought for $20.00, the maximum loss is -$2000, and the profit potential is infinite if the stock continues to grow. To make a profit, the underlying stock must be worth more than $120.

When a LEAPS call or contract is sold, the credit gained remains the trade's maximum possible profit. More credit will be collected in this situation than with shorter-term options, and the breakeven range will be much higher. However, when selling naked options, the risk remains undefined beyond the premium earned.

Particular Considerations

A market index is a hypothetical portfolio comprised of numerous underlying assets that reflect a market sector, industry, or other collection of securities. For stock indices, LEAPS are available. Like single equity LEAPS, Index LEAPS enables investors to hedge and invest in benchmarks such as the S& P 500 Index (S&P 500).

Index LEAPS allows investors to watch the whole stock market or particular industrial sectors and take a bullish or bearish position using call or put options. Investors may also use index LEAPS puts to protect their portfolios from market downturns.

Premiums on Long-Term Equity Anticipation Securities (LEAPS)

Premiums are the costs of an options contract that are not refundable. LEAPS premiums are more significant than regular options in the same stock. The extended expiry date offers the underlying asset more time to make a substantial move and the investor more opportunity to benefit. 3 Option markets utilize this long duration and the contract's intrinsic value to establish the option's value, known as the time value.

The inherent value of an option is the estimated or projected value of how likely it is to create a profit based on the difference between the asset's market and the strike price. This value might include profit earned before the acquisition of the contract. To place the inherent value, the contract writer will apply the fundamental study of the underlying asset or company.

As previously stated, the option contract has a base of 100 shares of the asset. So, if the option buyer pays $6.25 for Meta (FB), previously Facebook, the entire premium will be $625 ($6.25 x 100 = $625).

The stock's volatility, the market interest rate, and whether or not the asset pays dividends are all elements that might influence the premium price. Finally, the option will have a theoretical value generated via applying several pricing models throughout the contract. This shifting price reflects how much the contract holder may get if they sell it to another investor before it expires.

Shorter-Term Contracts vs. Long-Term Equity Anticipation Securities (LEAPS)

Investors may also acquire access to the long-term options market without employing a mix of shorter-term option contracts using LEAPS. Short-term options have a one-year maximum expiry date. Without LEAPS, investors who wanted a two-year option would have to buy a one-year option, wait for it to expire, and then buy another one-year option.

This procedure, known as rolling contracts over, exposes the investor to market fluctuations in the underlying asset's price and extra option premiums. With only one transaction, the longer-term trader may get exposure to a long-term trend in a particular investment.

Long-Term Equity Anticipation Securities Types (LEAPS)

Calls

Equity LEAPS call options to enable investors to profit from possible stock price increases while spending less money than if they bought the stock outright. In other words, the premium for an option is less expensive than the cash required to purchase 100 shares directly. Like short-term call options, LEAPS calls enable investors to exercise their options by buying the underlying stock at the strike price.

Another benefit of LEAPS calls is that the holder may sell the contract at any moment before it expires. The premium differential between buying and selling prices might result in a profit or loss. Any costs or charges paid by the broker to acquire or sell the contract must also be included.

Puts

If you hold the underlying stock, LEAPS puts give you a long-term hedge. Put options increase value when the underlying stock price falls, possibly offsetting the losses experienced by holding the stock. In other words, the put may assist mitigate the impact of dropping asset values.

An investor who has shares of Company XYZ and wants to keep them for the long term, for example, could be concerned that the stock price will drop. The investor might buy LEAPS puts on XYZ to protect the long stock position against negative swings to alleviate these fears. LEAPS puts allow investors to profit from price drops without selling short the underlying stock.

Borrowing shares from a broker and selling them with the assumption that the stock will continue to devalue by the time it expires is known as short selling. The shares are acquired upon expiration, preferably at a lower price, and the position is netted off for a profit or loss. On the other hand, short selling may be exceedingly dangerous if the stock price increases rather than falls, resulting in substantial losses.

Long-Term Equity Anticipation Securities: Benefits and Drawbacks (LEAPS)

Investing in long-term equity anticipation securities has numerous essential advantages and disadvantages. Here are a few of the more essential ones.

Advantages

A LEAPS contract's extended-term permits you to sell the option.

You may utilize a LEAPS contract to protect your investments against long-term market swings.

Several LEAPS options are available for those who want to invest in stocks indices, enabling you to hedge your bets against market volatility. You may also take a bullish or negative position on the market as a whole rather than individual stocks.

LEAPS' pricing is less affected by the underlying asset's movement. If the price of the underlying asset changes, the contract's fee will not necessarily alter dramatically.

Disadvantages

LEAPS premiums are substantially higher than those for other forms of investments.

Your money is bound and locked up for the contract's life since you're investing for the long term. This implies that you may not be able to take advantage of another beautiful investing opportunity.

You may be vulnerable to market or particular company downturns, which might harm your total position.

LEAPS prices are very volatile and susceptible to market and interest rate swings.

Long-Term Equity Anticipation Securities in the Real World (LEAPS)

Let's imagine an investor has a stock portfolio that mainly consists of S&P 500 components. The investor feels that a market correction is likely in the next two years and, consequently, buys index LEAPS puts on the S&P 500 Index to protect against potential losses.

The investor purchases a December 2021 LEAPS put option on the S&P 500 with a strike price of 3,000 and pays $300 in advance for the right to sell the index shares at that price on the option's expiry date.

If the index falls below 3,000 by expiration, the portfolio's stock holdings will likely decline, but the LEAPS put will rise in value, helping to offset the portfolio's loss. If the S&P 500 increases, however, the LEAPS put option will expire worthless, leaving the investor with a $300 loss.

Purchasing Stock vs. LEAPS

Assume you wish to buy many shares of Company XYZ. It's now selling at $14.50, and you've got $14,500 to put into it. You believe that XYZ will rise significantly in the next year or two. Therefore you want to put your money into the stock. There are three possibilities. The stock may be purchased outright, on margin, or using LEAPS.

Buying on margin entails borrowing money from your broker and securing the loan with your stock as collateral. It may seem handy, but you may lose more money than you invested. 3

Buying on the Spot or the Margin

You could purchase 1,000 shares of stock outright with your $14,500 or borrow on margin and leverage yourself 2 to 1, bringing your total investment to $29,000 and 2,000 shares of stock with an offsetting debt of $14,500. However, if you get a margin call, the stock crashes, or you cannot transfer cash from another source into your account, you may be compelled to sell at a loss.

You'll also have to pay interest for the privilege of borrowing money on margin.

Utilizing LEAPS

If you don't like this degree of exposure, you may want to explore LEAPS instead of ordinary stock. First, you'd check at the Chicago Board Options Exchange's (Cboe) pricing tables and discover that you may buy a call option on Company XYZ with a strike price of $17.50 that expires in two years. 4 That implies you may purchase for $17.50 per share between now and the expiry date. This option comes at a cost or premium. The call options are also available in 100-share contracts.

A call option allows you to acquire shares at the strike price for a certain period.

Let's say you decide to spend your $14,500 on 100 contracts. Remember that each agreement covers 100 shares; thus, utilizing your LEAPS, you would have exposure to 10,000 shares of Company XYZ. Assume you pay a $1.50 premium per share, and $1.50 multiplied by 10,000 shares is $15,000.

Your investment objective was rounded up to the next accessible value, but the stock is presently trading at $14.50 per share. You had the option of purchasing it for $17.50 a share, for which you paid $1.50 per share. As a result, $19 is your breakeven point.

Using LEAPS, the Result

On an investment of merely $1.50 per share, your net profit on the transaction would be $6 per share. By employing LEAPS instead, you transformed a 72.4 percent increase in stock price into a 400 percent gain. Although your risk was raised, you were rewarded for it with the possibility of significant improvements.

For a $15,000 initial investment, you would receive $60,000 ($6 capital gain per share on 10,000 shares), compared to the $10,500 you would have earned if you had purchased 1,000 shares of the company outright at a share price of $14.50 and it climbed to $25 per share over time.

Buying it on margin would have netted you $21,000, but you would have avoided the possibility of a wipe-out since anything beyond the $14.50 purchase price would have been a profit. You would have received cash dividends during your holding term, but you would have been required to pay interest on the margin you borrowed from your broker.

You might have been vulnerable to a margin call if the market had fallen.

LEAPS vs. Stocks

There are several distinctions between a joint-stock investment and an option investment. An option, unlike ordinary stock, has a finite life. Every choice has an expiry date, although common stock may be held forever. If an investor does not close out or exercise an option before it expires, the financial instrument ceases. Consequently, even if an options investor accurately predicts the direction in which the underlying stock will move, the investor may not benefit unless the person also indicates the movement's time.

Investors in options risk losing their entire investment in a short period and with tiny moves in the underlying stock. Unlike the purchase of ordinary stock for cash, the purchase of an opportunity requires leverage. The option contract value will vary by a higher proportion than the value of the underlying interest due to leverage.