What Are LEAPS Options?
What are LEAPS Options? LEAPS stands for Long-term Equity Anticipation Securities. LEAPS are options with contracts that are over one year in length but generally have up to three years until their maturity date, from their date of issue. They don’t differ from shorter-term options other than their length of time until their maturity. LEAPS were first offered for trade-in 1990 and have become commonplace.
What Is a Leap Option Strategy?
Having a longer time to maturity means that long-term LEAPS holders will also be exposed to lengthy price movements. Just like with shorter-term options, a “premium” is paid for the “right” to buy or sell at the option’s strike price. The strike price is the price at which the stock is traded at its expiration (buy or sell 100 units of the asset stock/index/etc. at the strike price).
If the stock price is higher than the strike then the owner of the option is “in the money” and can sell at any time for a profit. If “out of the money,” the owner is hoping to be in the money before the expiration date where they will lose the premium paid if still out of the money. Any LEAPS option is for 100 shares/units of the underlying asset.
Because of the long-term nature of LEAPS, the market interest rate, as well as volatility, can affect the option’s value.
Because LEAPS contracts have a longer duration, their premiums are higher. The longer expiration date allows the option’s asset more opportunity to make substantial movements. As a result, giving the option buyer a profit. Options marketplaces use this time value. As well as the intrinsic value, a calculated value of the likeliness of profit using the difference between the current market price and the strike price, to determine the contract’s premium.
The intrinsic value may already include a profit with the market/strike price difference. The contract writer will add this to their fundamental asset analysis price to determine the ultimate premium paid.
Besides time and intrinsic value, a stock’s volatility, the current market interest rate, any dividends payable as well as a theoretical value created from an ever-changing pricing model will go into the fundamental analysis portion pricing of the premium. Because of all of these inputs, the premium price is constantly changing. This change indicates the price the holder could receive if they sell their contract to another investor prior to its expiration.
If ABC stock has a premium of $6.00 and the LEAPS contract is for 100 shares, the total contract premium is $600.
LEAPS versus Short Term Options
LEAPS were created to provide long-term options without the use of several short-term contracts. This includes a maximum of a one-year expiration. While simultaneously purchasing a new contract on the expiry of an old contract. It’s known as a process called “rolling contracts over”. This was a method employed previously.
The rollover method exposed the buyer to market price changes and additional premiums. This is eliminated for longer-term traders while exposing them to longer trends of the underlying asset in a single trade.
LEAPS Calls and Puts
LEAPS calls allow an investor to benefit from a stock’s rise without the need for significant upfront capital; only the premium. Like any shorter-term call option, a LEAPS call gives a right to purchase at the strike price. The contract holder can also sell their call contract at any time before the expiry date. This comes with the potential for a potential profit or loss, less any commissions or brokerage fees for the exchange.
LEAPS puts give investors a long-term hedge when owning the underlying asset. All shorter-term and LEAPS puts gain value when the asset’s price declines. This offsets the losses of the held stock, cushioning the blow. Say you have shares in ABC that have risen sharply but wish to hold long term(for tax reasons). And you fear losing your gains. You could purchase the LEAP put as insurance hedging against a crash in your long position.
LEAP puts are also a way to gain from stock declines without selling a stock short. This involves borrowing the shares, selling them, and expecting the continued price decline until expiry. The shares get purchased at expiry. And the gain or loss is netted out, exposing yourself to high risk and significant losses if the price rises.
Like single asset LEAPS there are index LEAPS allowing hedging against the S&P500, other indexes, and specific sectors. You are gaining an insurance policy against big market downturns by purchasing an S&P index LEAPS put. Such a put tracks the 500 stocks of the S&P index, and would be in the money if the market goes down, providing a hedge for a long portfolio of broad stocks.
How to Use LEAPS Options?
Imagine a world where we have had a 12-year run-up in stock prices since February 2009 (not hard to imagine).
S&P500 Price From 2008 To Today
We believe that there will be a market correction after a hypothetical global pandemic within the next two years. Therefore, we purchase a LEAPS S&P500 index to hedge against this downfall. We pay $412.60 for a $4200 strike price LEAPS put that expires in 2 years.
If the S&P falls below $4200 before expiring, we are in the money, and though our portfolio will be decreasing in value, the value of the put will be increasing. If the S&P stays higher than $4,200, our put will expire, worthlessly losing the $412.60 premium; however, our portfolio will still be intact and maybe higher.
LEAPS contracts are a great way to hedge as well as short a stock with only limited funds. These options have a specific time and place to be used and can be to great advantage for long-term asset holders who wish to hedge against disaster for a small price.
As always, never put at risk more than you can afford to lose with any single position, and good luck with all of your trades.