Options LEAPS (Long-term Equity Anticipation Securities) are long-term options contracts that allow investors to gain exposure to stocks for a longer period of time than traditional options.
LEAPS offer their own advantages and disadvantages but are relatively simple in how they work and the strategies behind them.
So if you’re interested in learning more about how options leaps work – then keep reading!
What are Options LEAPS?
Options LEAPS, or Long-Term Equity Anticipation Securities, are long-term contracts that give investors the right (but not obligation) to buy or sell an underlying asset at a predetermined price over a certain period of time.
They specifically refer to those options contracts with expiration dates at least one year out in time – but potentially up to three years.
- Options LEAPS are publicly listed options with expirations at least one year out in time.
- Due to the long time duration, LEAPS are far less affected by time-decay.
- The cost, or premium, for LEAPS will be higher than options with shorter term expiration – but still less than the cost of owning the underlying stock.
Advantages and Disadvantages of LEAPS
LEAPS, or long-term equity anticipation securities, come with their own set of advantages and disadvantages. This is no different than any other investment so just be aware of all the risk before getting started.
Advantages
- Less sensitive to time decay: Due to the longer duration, LEAPS are far less affected by time decay than shorter-duration options. As the option approaches expiration, time-decay will begin to increase exponentially.
- Less sensitive to stock movement: As options near expiration, gamma begins to increase, leading to more volatile movement in the options. Even small movements in stock price can cause short-term options to swing dramatically in value. Whereas long-term options, or LEAPS, have more consistent moves.
- Less capital required than buying the stock: Long-term investors can use LEAPS to take directional trades on specific stock for less capital than purchasing the underlying stock. Also leading to less risk in the event the stock moves significantly against you.
Disadvantages
- More expensive than short-term options: The extended time duration leads to greater time value priced into the premiums. This means LEAPS can be much more expensive and require a higher level of capital.
- Sensitive to changes in interest rates: Changes in interest rates, or the risk-free rate, has the greatest impact on longer-term options. If interest rates decline, it’s expected for the price of the calls to decline as well.
- Sensitive to changes in volatility: The further the option is from expiration, the greater its sensitivity to changes in volatility. As volatility expands, expect the long options (calls and puts) to increase in value.
Main Considerations
One of the main drawbacks of Options LEAPS is time decay. As the expiration date approaches, their value decreases due to the fact that their intrinsic value is tied to how much time is left until expiration.
This means that if you plan on holding onto your Options LEAPS for longer than one year, you must be aware of this factor and take it into consideration when making investment decisions in order to maximize profits and minimize losses.
You’ll also want to know LEAPS may have liquidity risk. Since these contracts have a long-term horizon, they may not always be easy to trade or liquidate quickly in case you need cash urgently or want out from an unfavorable position.
Otherwise, they offer a great way for investors to get into the options market without having to commit as much capital as purchasing the underlying stock itself.
Strategies for Trading Options LEAPS
Unlike regular options, which expire after a few months or weeks, Options LEAPS can last up to three years. This makes them ideal for investors who want to take advantage of long-term trends in the stock market without having to constantly monitor their positions.
One strategy for trading Options LEAPS is covered calls. With this strategy, an investor buys shares and then sells call options against those shares at a strike price higher than the current share price. If the share price rises above the strike price before expiration, then they will be able to sell their shares at a profit while still keeping some downside protection if it falls below the strike price before expiration.
Another strategy for trading Options LEAPS is protective puts. With this strategy, an investor buys put options on their underlying stock position with a strike price lower than where they bought it. The long-dated puts would then act as a hedge in the event the stock has a significant decline.
Example of Option LEAP
For example, let’s say you believe XYZ will increase in value significantly over the next 1 – 2 years. If XYZ was currently trading for $1,000 per share, purchasing 100 shares of stock would require a $100,000 investment.
Instead of buying the stock, you instead choose to purchase a 1000-strike call with an expiration date two years from today. The total cost of the call is $175, requiring a total investment of $17,500 for a single contract.
In the option is held until the expiration date, you’ll need XYZ stock to move above $1,175 a share to recoup the cost of the contract. If it’s below your 1,000-strike at expiration, you would take a complete loss on the trade.
Although it still requires a capital investment of $17,500, this is far less than what would be required to buy the shares themselves. Thus allowing you to leverage your capital and take advantage of the upward move in the stock.
FAQs Related to Options LEAPS
Are LEAPS options worth it?
LEAPS options can be a great way to invest in the stock market for those who are willing to commit their capital for an extended period of time.
LEAPS, which stands for Long-term Equity Anticipation Securities, allow investors to buy and sell call or put options with expiration dates up to three years away. This gives traders more flexibility than traditional short-term options, as they have more time to wait out any potential price fluctuations in the underlying asset.
What is the downside of LEAPS?
The downside of LEAPS is that they require a larger upfront investment than regular options due to their extended life span. The further out in time, the more time value is priced into the contracts.
Which LEAPS should I buy?
When deciding which LEAPS to buy, it is important to consider the underlying asset and its expected performance. If you are bullish on a particular stock or index, then buying long-term call options (LEAPS) may be a good choice.
On the other hand, if you are bearish on an asset, then purchasing put options (LEAPS) could be more appropriate. You’ll also want to consider the appropriate strike depending on the risk you’re willing to accept.
When should I exercise LEAPS?
It will rarely make sense for you to exercise option LEAPS. Due to the time value priced into the contract, exercising will typically leave you will less return than simply selling the contract itself. However, exercising may be needed if the options have low liquidity and you’re unable to sell for the intrinsic value remaining or for tax purposes.
Ultimately, only you can decide when to exercise your LEAPS options; however, these guidelines can help guide you toward making an informed decision that best suits your needs and goals as an investor or trader.
Do you pay taxes on LEAPS?
Yes, if the option is sold for a profit, the gains are taxable. If the option is instead exercised, you’ll be left with shares of the underlying stock at the strike price and any gains will be taxed when the stock position is sold.
If the LEAP is held for at least one year and one day, the gains will be taxed at the long-term capital gains rate. If held for less than a year, the option will be taxed at the short-term capital gain rate.
Conclusion
Options LEAPS can be a great way to invest in the stock market for those who are looking for long-term investments. They offer investors the ability to buy and sell options with expiration dates that extend up to three years, allowing them to take advantage of potential price movements over a longer period of time.
While there are some disadvantages associated with Options LEAPS such as higher premiums and limited liquidity, these can be managed by using strategies such as buying deep in-the-money options or selling covered calls against your position.
