LEAPS Options

Long-term equity anticipation securities (LEAPS) are options trading contracts with an expiration period of one to three years. As a result, LEAPS options give investors an extended period to profit from the underlying asset. In comparison, traditional options contracts are shorter, less than a year.

The LEAPS option grants investors the right to buy or sell a particular asset at a predetermined price (strike price). But it is not an obligation. The option that allows an investor to buy is called the call option, and the option that gives the investor the right to sell the asset is called the put option.

• Long-term equity anticipation securities (LEAPS) are options contracts with a longer duration—expiration period of one to three years.
• The investor must pay a fee upfront to purchase LEAPS—known as the premium. If LEAPS are held for more than a year, a 15% capital gains tax is imposed.
• LEAPS are less expensive than stocks. Just like stock prices, there are fluctuations in options prices as well. Unlike stocks, LEAPS contracts do not offer dividends or voting rights.

LEAPS is an abbreviation for ‘long-term equity anticipation securities.’ It was introduced in October 1990 at the Chicago Board Options Exchange. It was a huge success; since then, LEAPS options investment has become popular and increased rapidly.

Options trading is a contract between a buyer and the seller; the option holder bets on the future price of an underlying security or index. Upon expiry, the holder can purchase or sell at the strike price. Although it is optional, the investor is not obligated to sell.

Traders maximize their returns and minimize risks by holding a short or long position. To predict future trends, traders apply different technical indicators and determine the direction of stock movement, its range, and the time frame.

LEAPS trading also allows investors to buy or sell an underlying asset at a premium (price) below or above the strike price. If the period is longer, it is more beneficial to the traders. Longer terms yield more profits than monthly trading due to reduced risks.

It is classified into the following subtypes:

1. Call LEAP Option: The cost of buying options by paying the premium is cheaper than stock trading. LEAPS allows investors to purchase the underlying asset at the strike price. It has additional advantages that let investors sell the option at any time (before the expiration date). LEAPS facilitates sufficient time for the investors—the spread between the premium and the selling price generally yields profit.
2. Put Option: LEAPS put option allows investors to sell the stock when the underlying asset's value decreases at the pre-determined price.
3. Rolling LEAP: Here, the duration of the options contract is extended before its expiration date. Usually, investors purchase rolling plans when they encounter losses—to prevent subsequent losses.

Let us understand how to trade LEAPS options.

LEAPS are traded in secondary markets. Secondary markers facilitate transactions between two investors in the market—one’s a buyer, and the other is a seller. But, before investing in LEAPS, the investor needs to consider the following points:

• The term ‘exit position’ is where the underlying asset reaches the threshold limit—at the verge of losses.
• The options chain list provides information about contracts, risks, and potential gains. This information can be obtained from various websites like the NASDAQ.
• The delta of an option is necessary to track the price of an asset. It helps evaluate the probability of options amidst changing stock prices.
• Above all, investors need to manage risks and rewards. Therefore, investors must monitor the Out-of-the-money (OTM) and In-the-Money (ITM) values. The term ‘In the money’ reflects a scenario where the strike price is lower than the stock's market value.

The payoff graph for buying a LEAPS contract that will single-legged resembles an identical loss and profit potential as any long put or long call option. The payment made for initial debit at the entry point limits the risk while there is unlimited potential concerning profit. 

Let us get a better idea regarding this concept by observing the graph below:

The cost incurred to get into a long LEAPS contract is much higher compared to shorter-term options owing to the longer timeframe until expiry. This has an effect on the break-even point, which is much farther when compared to the strike price. One must note that the math stays the same. The stock price needs to be above the sum of the strike price and the debit spread for a trader to be profitable. 

For instance, in case Sam, a trader purchased a long call option with a $120 strike price for $66.67, the maximum loss will not exceed -$8000 (approximately). Moreover, the potential profit will not be subject to any restriction. In other words, the profit will keep rising if the asset price goes on increasing too. That said, the underlying asset price needs to be higher than $140, i.e., the break-even point, as shown in the diagram, to record financial gains. 

Let us look at the LEAPS options examples to understand the concept better:

Example #1

Let us assume that Bradley wants to buy shares of Amacon Ltd., listed on a stock exchange. The share is trading at $12 per share. Now, Bradley wants to invest $12000. Assuming prices will rise, Bradley invests in LEAPS.

After considering the stock's current price, Bradley buys a call option for Amacon Ltd. shares. He purchases the share at the strike price of $15 per share. The option expires in one and a half years. LEAPS requires investors to pay an upfront fee (premium).

There is a slot of 100 shares in the contract, and Bradley purchases Amacon Ltd. shares worth $12000. For the purchase, he pays a premium of $1.

Amacon Ltd. is currently trading at $12 but can be purchased as a call option at a strike price of $15 per share, so the breakeven point (no profit - no loss) will be $17 per share. If the share price reaches $22 per share, the profit would be as follows:

• LEAPS Profit = Future Price – Strike Price
• LEAPS Profit = $22-$15
• LEAPS Profit = $7 per share

Let's subtract the premium from the total profits ( $7-$1 = $6). The risk is higher, but Bradley earned a significant profit.

Example #2

An investor wants to invest in an SUV company and fears price volatility. To mitigate the fall in share prices, the investor can use the LEAPS put option and hedge against price movements for an extended period.

Let us look at LEAPS options' pros and cons:

• LEAPS gives an investor adequate time to use call options and put options.
• LEAPS  price is not sensitive to the underlying asset, meaning the increase or decrease in the price of the derivatives does not affect LEAPS options contract price.

Now the Cons:

• They are more expensive than short-term contracts.
• LEAPS are riskier than short-term contracts.
• The long lock-in period does not allow the investor to take advantage of other investment opportunities (opportunity cost).

Now, let us look at LEAPS options vs stocks vs options comparisons to distinguish between them.

• LEAPS options are less expensive than stocks. The price of options goes in tandem with the change in the stock price.
• LEAPS option does not offer dividends or voting rights. In contrast, investors receive dividends and voting rights directly if they invest in stocks.
• LEAPS option is more expensive than other options contracts.
• LEAPS option comes with an extended period of one to three years. In contrast, short-term options contracts come with monthly tenures—three months, six months, and nine months.

This article has been a guide to what are LEAPS Options. Here, we explain how to trade it, compare it with options and stocks, its examples, pros & cons. You can learn more about it from the following articles -

• Options On Futures
• Options Trading
• Options Spread