LEAPS, or long-term equity anticipation securities, are publicly traded options contracts with expiration dates longer than one year. Typically, LEAPS may expire up to three years from the issue date. They function similarly to most other listed options, except for their longer expiration durations.
A LEAPS contract grants the buyer the right, but not the obligation, to purchase or sell (depending on whether the option is a call or a put) the underlying asset at a predetermined price on or before its expiration date.
Key Takeaways
- Long-term equity anticipation securities are listed options contracts that expire in more than a year.
- These contracts are ideal for options traders looking to trade prolonged trends.
- LEAPS can be listed on a particular stock or an index as a whole.
- They are often used in hedging strategies and can be particularly effective for protecting retirement portfolios.
- The premiums for LEAPS are higher than those for standard options in the same stock, but often lower than the cost of the underlying stock’s shares.
Understanding Long-Term Equity Anticipation Securities (LEAPS)
LEAPS Definition and Function
LEAPS are akin to short-term options but with later expiration dates. The extended maturity allows long-term investors to gain exposure to prolonged price movements. Investors pay a premium or upfront fee for the ability to buy or sell above or below the option’s strike price. The strike price is the agreed level at which the underlying asset converts at expiry.
For example, a $25 strike price for a GE call option allows an investor to buy 100 shares of GE at $25 upon expiry. If the market price is higher than the strike price, the investor will exercise the $25 option. Should the price be less, the option expires worthless, and the investor loses the premium paid.
Financial Considerations and Market Influences
Investors tie up funds in these long-term contracts. Market interest rates and asset volatility among others factors may impact the value of these options, contingent on market direction and movement.
Index LEAPS
A market index represents a theoretical portfolio consisting of several underlying assets reflecting a market segment, industry, or other security groups. Just as with single stock LEAPS, index LEAPS allow for hedging and investing in indices such as the S&P 500. Index LEAPS enable portfolio strategies tracking the entire stock market or specific industry sectors using calls for bullish positions or puts for bearish stances.
LEAPS Premiums
Premiums are the non-refundable costs associated with an options contract. LEAPS premiums are higher than for standard options because the longer expiration date gives the underlying asset more time to make a significant move. Known as the ‘time value,’ this timeframe is factored into the option’s value alongside its intrinsic value—the projected profit likelihood based on market price and strike price difference.
Example
For instance, if the premium for Meta (formerly Facebook) is $6.25, an option buyer would pay $625 total ($6.25 x 100 shares), given each options contract represents 100 shares.
Long-Term Equity Anticipation Securities vs. Shorter-Term Contracts
Without LEAPS, investors would have to use a series of shorter-term option contracts to maintain long-term positions, requiring rolling old contracts into new ones which might increase exposure to market fluctuations and additional premiums. LEAPS simplify long-term trading and hedging with a single trade.
Types of LEAPS
Calls
LEAPS calls permit investors to leverage rising stock prices with less capital than direct share purchases. Like short-term calls, LEAPS calls allow investors to exercise their options to buy shares at the strike price. These can be sold anytime before expiration, with potential profit or loss based on premium differences and any brokerage fees.
Puts
LEAPS puts offer a long-term hedge, aiding in protecting against downward price movements. For instance, an investor holding Company XYZ shares could purchase LEAPS puts as protection against falling prices, helping mitigate potential portfolio losses without resorting to the riskier strategy of short selling.
Advantages and Disadvantages of LEAPS
Advantages
- Long timeframes allowing selling the option
- Hedge against fluctuations in your long-term portfolio
- A multitude of LEAPS options available for equity indices, allowing broad market hedging and stance taking
- Contract prices are less sensitive to short-term movements in the underlying asset
Disadvantages
- Higher premiums compared to standard options
- Funds are tied up for a longer-term, potentially missing new opportunities
- Market and individual company movements can negatively impact your position
- Prices are sensitive to volatility and interest rate changes
Pros and Cons of LEAPS
Pros:
- Long time frame facilitates option selling
- Useful for hedging long-term holdings or portfolios
- Available for equity indices
- Less sensitivity to brief underlying movement
Cons:
- Higher premiums
- Investments tied up for long durations
- Susceptible to adverse market/company movements
- Prices highly influenced by volatility and interest rate swings
Example of LEAPS
Imagine an investor with an S&P 500 focused portfolio fears a potential market correction. They might purchase S&P 500 Index LEAPS puts to hedge against undesirable market drops. For instance, purchasing a December LEAPS put with a strike price of 3,000 for $300 implies protective leverage against falls below 3,000 while limiting the loss to the $300 premium if the market price rises.
Are LEAPS a Good Investment?
As with any investment, LEAPS come with their risk and reward pyramid. They might offer a cost-effective path to long positions than direct stock purchases for some, with movements aligning or inversely corresponding to the underlying security depending on the call or put nature.
When Should You Buy LEAPS?
Consider LEAPS calls for a medium-term speculated stock rise, or LEAPS puts as a medium-term hedge against existing investments.
Can You Lose Money with LEAPS?
Yes, there is a risk of losing the entire investment if a LEAPS expires worthless, and selling LEAPS carries a theoretically unlimited loss risk if the underlying security moves unfavorably.
Do You Pay Taxes on LEAPS?
Yes, gains from selling LEAPS are taxable and need to be reported. Contracts held for over a year and a day get taxed at long-term capital rates; shorter durations attract short-term capital gains tax.
What Is the Downside of LEAPS?
Primary downsides include upfront capital requirements for the premium and generally higher costs than shorter options owing to the longer timeframes suspecting to intrinsic value changes over time.
The Bottom Line
Introduced by the Chicago Board Options Exchange (CBOE) in 1990 to meet market demand, LEAPS have now matured into essential tools within options trading. Investors need to weigh and understand their bespoke risks and rewards their extended expiration horizons entail, tailoring these long-term options to fit their overall strategy.
Related Terms: options contracts, expiration date, underlying asset, strike price, market index.
References
- Cboe Global Markets. “LEAPS® Options”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- Cboe Global Markets. “Equity LEAPS® Options Product Specifications”.
