What are LEAPS?
LEAPS ( Long Term Equity Anticipation Securities) are some of the most common publicly traded options contracts that are however often underrated by the trading community. The main feature that also differentiates LEAP’s from other options is that the expiration date of those options are by default longer than those of other options.
Predominantly, LEAPS are those options with an expiration date of a year or longer. However, most other features of those options are analogous to those of other types of options contracts. Depending on whether its a “call” or “put” option (call options allow owners to buy stocks and put options allow owners to sell stocks), LEAPS grant the holder the right, but not the obligation, to purchase or sell the underlying asset before the contract’s expiration date.
Understanding the Process
In order to fully analyse the advantages and disadvantages of trading LEAPS, it is first paramount to comprehend the process involved in it. First and foremost, it is crucial to note that the main advantage of trading LEAPS is that longer expiration times allow investors to gain access to prolonged price movements of the underlying asset.
Often, investors purchase call LEAPS contracts instead of shares of stock, consequently gaining access to identical long-term investment benefits with less capital outlay and a leveraged effect on profits. This happens because LEAPS are, in essence, stocks with reduced price tags, since they are offered at option contract prices.
The process involved in investing in LEAPS can be construed as the following. Investors pay an upfront fee (premium) for the possibility to buy or sell (depending on whether the option is “call” or “put”) above or below the option’s strike price (the underlying asset’s price at the time of expiry).
Furthermore, it is important to add that the premium for LEAPS are generally higher than the ones for standard options in the same stock because it gives the investor a larger time span to make a profit on it.
One of the most important things to remember when investing into any options but LEAPS especially is that the funds that have been invested into those contracts are tied up in the long term and that the market volatility can either make these options (and therefore the investments) more or less valuable. Another important side note is that LEAPS are not marked as “LEAPS” on trading platforms and therefore, in order to identify them as such, one needs to look at the expiration date of the contract ( again, LEAPS last more than 1 year).
Besides, when trading LEAPS, it is important to look at the “Greeks” ( this term refers to a set of statistics associated with any option contract). When dealing with LEAPS, those are theta and delta, where theta measures time decay ( the closer the option gets to expiration, the more it loses value, especially if it’s in the money). Theta will affect the value of the LEAP option increasingly as it gets closer to its expiration date. Theta time decay is said to ‘accelerate’ in the last month, and so the option’s contract loss in value.
Leaps Trading Strategies
As with any other trading contract, there are some strategies for trading LEAPS that make it much more likely to make a healthy profit as an investor. In the case of LEAPS, the strategy must be contrived in a way that justifies investing into them and not the stock itself. One of such strategies is described below.
The first thing an investor can do when dealing with LEAPS is “looking forward to a bull run of a specific stock a year from now”. That is done after a fundamental analysis (analysing the profitability of a company and estimating the fair value of their stock, instead of looking purely at the history of the stock price (technical analysis)) of a company.
If bearish (having a negative outlook), you can buy a LEAP put option at a specific price allowing you to sell the stock at a price that would be higher than the future stock price, thus making a healthy profit. You won’t be forced to close your trade if the price closes below the stop loss limit and therefore won't receive a margin call. Furthermore, unlike shorting a stock your losses are much more limited. If you expect a strong correction or crash, LEAPS allow investors to be safe from timing errors.
LEAPS have longer expirations, offering more time for the underlying stock to play out your envisioned move. LEAPS are seen as a unique way to gain leveraged returns, with capped max losses and less risk due to the additional time (perfect timing in the market is not necessary). Moreover the option's time decay (theta, or however much value the contract loses daily due to time) is smaller compared to shorter timed options. Even though LEAP options, like all other options experience time decay, they lose their time value much slower at the beginning of the contract's life cycle because the expiration day is so far in the future. This gives LEAPS buyers a large advantage over investors who chose to go short on other options.
Moreover LEAPS offer a certain advantage in the sense of opportunity cost. With a LEAP, you will be able to profit from a stock's movement for a large amount of time based on an original spot price and market condition which might not be accessible anymore if you were to take repetitive, cheaper, shorter dated options (where you would need to buy your follow up contracts at possibly less advantageous market conditions).
In addition to that, LEAPS can be used as an effective tool for hedging. “Shareholders can buy LEAPS puts to hedge against a long position they have. Index LEAPS can also be utilized as a large-scale protective put for your portfolio, or to hedge against sector-specific headwinds.” (Schaeffer, "Pros and Cons of Trading LEAPS")
On the other hand, the fact that there is added time value also makes LEAPS much more expensive than shorter term option contracts with the same strike price. This creates higher break even points that are harder to reach for investors, but also forces investors into risking more capital (don't forget, although LEAPS offer huge and potentially unlimited profits with a max loss- if your option expires worthless, or slightly under the strike price, you lose the entirety of your more consequent investment) . Besides, LEAPS are sometimes not readily available or lack liquid for less traded underlying assets.
The following example is helpful in facilitating the understanding of LEAPS and illustrating one of such contracts. In this example, Apple will be used to illustrate LEAPS. As of May 2019, the stock price was 210.92$
It is expected that the stock price of Apple will stay over $185 by June 2018. The part of this that can be confusing is why would one sell a call option for a price lower than the strike price of the stock (as of may 2019 the price is $210.92). This is so because the option buyer has to take into account the option premium when buying LEAPS and therefore the breakeven price would be: $185 + $45.61 = $230.61 which guarantees the investor a healthy profit.
In conclusion, LEAPS are a very effective way to make leveraged profits as an investor without needing perfect timing. They therefore allow to differentiate portfolios and are strong tools for hedging. However, one should only invest into them if they are ready to deal with the fact that their funds will be tied up in a single option contract for a long period of time and that the risk of losing the entirety of their initial investment is quite high. LEAPS might not be made for smaller investors who could be forced to put in too much of their portfolios in a single, risky financial instrument.