Perfect for Beginners!
Free Trading Education! Free Demo Acc!
Get Your Sign-up Bonus Now:
LEAP Options (A Simple Explanation Guide)
How would you like to take advantage of the long-term investment benefits offered by stocks at a reduced price tag? If so, then consider investing in LEAP options.
LEAP options (or LEAPs) are option contracts that expire at least one year from the date of purchase.
The acronym LEAP stands for “Long-term Equity Anticipation.”
LEAPs are more affordable than stocks because they’re offered at option contract prices. They’re long-term investments so they give you plenty of time to take advantage of stock price movements without the high cost of the underlying securities.
In this guide, I’ll go over LEAP options so you can determine if they have a place in your trading strategy.
Playing the Long Game
Many traders often buy or sell options that expire within the next month or two. Although that kind of a strategy can offer some significant returns, it also gives the underlying stock very little time to move up or down.
LEAP options solve that problem with a contract expiration that’s at least a year out. The stock has a longer time period to follow the trend line that you predicted and ride out day-to-day price swings.
Unfortunately, LEAPs more expensive than short-term contracts for precisely that reason. You’ll pay a premium when you invest in LEAPs.
That shouldn’t matter if the stock moves in the right direction. The price of the option contract should increase accordingly.
Calls or Puts?
Should you buy call options or put options when investing in LEAPs? The answer is: it depends.
If your outlook for the underlying stock is bullish over the long haul, buy call options.
Perfect for Beginners!
Free Trading Education! Free Demo Acc!
Get Your Sign-up Bonus Now:
On the other hand, if you think the price could drop precipitously over the next year or so, buy put options.
The good news is you aren’t limited with LEAPs. You can buy either call options or put options.
Don’t Ignore the Greeks
When it comes to options trading, the pros pay attention to the Greeks. You should, too.
If you’re unfamiliar with the term “the Greeks,” it refers to a set of stats about any option contract. Those stats are identified by Greek letters.
Key in on two Greeks in particular when investing in LEAP options: theta and delta.
Theta measures time decay. The closer an option contract gets to expiration, the more it loses value. That’s especially true if it’s out of the money.
Keep in mind: theta also accelerates as the contract gets closer to expiration. In other words, the day-to-day time decay during the last week of the contract will exceed the day-to-day time decay when the contract still has months before expiration.
That’s why theta won’t affect LEAPs that much initially. However, time decay will become painfully noticeable as the contract gets closer to expiration.
Bottom line: it’s a great idea to buy LEAP options that are likely to spike in value well before expiration. That way, you won’t have to worry so much about theta.
The other Greek, delta, is one that you should look at closely before buying a LEAP.
Why? Because it measures how much the price of the option swings in relation to the price of the underlying stock.
A delta of .80, for example, means that the option price will rise 80 cents for every dollar that the stock price rises.
When you buy LEAPs, look for options with high deltas. That way, your investment will increase in value on an almost dollar-for-dollar basis with the underlying stock.
In-the-Money or Out-of-the-Money?
Should you buy in-the-money or out-of-the-money LEAPs? Once again, it depends.
If you’re unfamiliar with the phrases “in-the-money” and “out-of-the-money,” they refer to the price of the underlying stock in relation to the option contract’s strike price.
Call options are in the money when the strike price is less than the stock price and out of the money when the strike price is more than the stock price.
Put options are in the money when the strike price is more than the stock price and out of the money when the strike price is less than the stock price.
If you’re into a speculative trade, feel free to buy out-of-the-money LEAP options. Just keep in mind that you’ll pay a hefty premium compared to short-term contracts and the underlying stock will likely to need to move your way significantly before you see a decent return.
As a rule of thumb, in-the-money options have higher deltas. That’s why they’re a great choice for LEAPs.
Of course, in-the-money options are more expensive than out-of-the-money options because they’ve already “arrived.” But options that aren’t too far in the money are still much cheaper than the underlying stock.
Real-Life Example Using a LEAP Option
Let’s say Apple is trading at $175 per share. You think it’s going up significantly over the long term, so you decide to buy a LEAP option.
The $170 call option for a year out is currently trading for $24.00. You believe that Apple is going up at least $30 per share before the contract expires, so you think it’s got potential.
You check out the Greeks. That contract has a delta of 0.63. That means for every dollar that Apple stock increases in value, the option will increase 63 cents. That’s acceptable because you also know that delta will increase as the stock price increases.
The theta is -0.04. That means the option will lose 4 cents in value every day, all other things being equal. That’s also acceptable.
You buy the call option for $24. That means you spend $2,400 because options are sold in blocks of 100 shares ($24 x 100 = $2,400).
Sure enough, after several months, Apple reports record earnings and the stock price shoots up to $198 per share. The option you bought is now worth $41. You sell the position for $4,100 ($41 x 100).
That means your return is a whopping 70%!
Now compare that to what you’d get if you bought 100 shares of stock. You’d pay $17,500 ($175 x 100) for the position and sell the stock for $19,800 ($198 x 100). That would give you a return of just 13%.
So if you bought the stock you’d invest a lot more money for a much smaller return.
That’s what makes LEAP options attractive to so many traders.
Long-term Equity Anticipation Securities, or LEAPS®, are long-term stock or index options that expire more than 9 months in advance, and can last as long as 2.5 years. They are introduced by CBOE in 1990 to give investors more flexibility in using options in their portfolios. LEAPS trade like normal options but they allow investors to benefit from the appreciation of equities while placing a lot less money at risk than is required to purchase stock.
Not all optionable stocks have LEAPS listed for trading. LEAPS are usually available only for large cap stocks or smaller companies in hot sectors.
LEAPS® Expiration Cycle
LEAPS always expire in January and there are two series listed on a given stock at any time. After the May expiration, the nearest LEAPS will turn into a regular short-term option as the January cycle (June, July, October and January) begins. At this time, the next LEAPS series is listed for trading.
For example, in January 2007, there will be LEAPS listed that expire in January 2008 and January 2009. On the Monday following the May 2007 expiration date, the January 2008 LEAPS becomes a regular option and January 2020 LEAPS is added.
You May Also Like
Buying Straddles into Earnings
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]
Writing Puts to Purchase Stocks
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]
What are Binary Options and How to Trade Them?
Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]
Investing in Growth Stocks using LEAPSÂ® options
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPSÂ® and why I consider them to be a great option for investing in the next MicrosoftÂ®. [Read on. ]
Effect of Dividends on Option Pricing
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]
Bull Call Spread: An Alternative to the Covered Call
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]
Dividend Capture using Covered Calls
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]
Leverage using Calls, Not Margin Calls
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]
Day Trading using Options
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]
What is the Put Call Ratio and How to Use It
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]
Understanding Put-Call Parity
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]
Understanding the Greeks
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]
Valuing Common Stock using Discounted Cash Flow Analysis
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]
Long-Term Equity Anticipation Securities – LEAPS
What Are Long-Term Equity Anticipation Securities – LEAPS?
Long-term equity anticipation securities (LEAPS) are publicly traded options contracts with expiration dates that are longer than one year. As with all options contracts, a LEAPS grant a buyer the advantage, but not the necessity, to purchase or sell—depending on if the option is a call or a put—the underlying asset at the predetermined price on or before its expiration date.
Long-term equity anticipation securities are no different from short-term options except for the later expiration dates. Lengthier times until maturity allow long-term investors to gain exposure to prolonged price movements.
As with many short-term options contracts, investors pay a premium—upfront fee—for the ability to buy or sell above or below the option’s strike price. The strike is the decided upon price for the underlying asset at which it converts at expiry. For example, a $25 strike price for a GE call option would mean an investor could buy 100 shares of GE at $25 at expiry. The investor will exercise the $25 option if the market price is higher than the strike price. Should it be less, the investor will allow the option to expire and will lose the price paid for the premium. Also, remember each options contract—put or call—equates to 100 shares of the underlying asset.
An investor must understand that they will be tying funds up in these long-term contracts. Changes in the market interest rate and market or asset volatility may make these options more or less valuable depending on the holding and the direction of movement.
- Long-term equity anticipation securities are ideal for options traders looking to trade a prolonged trend.
- LEAPS can be applied to a particular stock or an index as a whole.
- LEAPS are often used in hedging strategies and can be particularly effective for protecting retirement portfolios.
Premiums are a nonrefundable cost to trade in the options market. The premiums for LEAPS are higher than those for standard options in the same stock. The further out expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. Known as the time value option marketplaces use this lengthy timeframe and the intrinsic value of the contract to determine the value of the option.
Intrinsic value is the calculated or estimated value of how likely the option is to make a profit based on the difference between the asset’s market and strike price. This value may include profit that already exists in the contract before purchase. The contract writer will use fundamental analysis of the underlying asset or business to help place the intrinsic value.
As mentioned earlier, the option contract has a basis of 100 shares of the asset. So, if the premium for Facebook (FB) is $6.25 the option buyer will pay $625 total premium ($6.25 x 100 = $625).
Other factors that can affect the premium price include the volatility of the stock, the market interest rate, and if the asset returns dividends. Finally, throughout the life of the contract, the option will have a theoretical value derived from the use of various pricing models. This fluctuating price indicates what the holder may receive if they sell their contract to another investor before expiration.
LEAPS vs. Short-Term Contracts
LEAPS also allow investors to gain access to the long-term options market without needing to use a combination of shorter-term option contracts. Short-term options have a maximum expiration date of one year. Without LEAPS, investors who wanted a two-year option would have to buy a one-year option, let it expire, and simultaneously purchase a new one-year options contract.
The process—called rolling contracts over—would expose the investor to market changes in the prices of the underlying asset as well as additional option premiums. LEAPS provide the longer-term trader with exposure to a prolonged trend in particular security with one trade.
Equity—another name for stocks—LEAPS call options allows investors to benefit from potential rises in a specific stock while using less capital than purchasing shares with cash upfront. In other words, the cost of the premium for an option is lower than the cash needed to buy 100 shares outright. Similar to short-term call options, LEAPS calls allow investors to exercise their options by purchasing the shares of the underlying stock at the strike price.
Another advantage of LEAPS calls is that they let the holder sell the contract at any time before the expiration. The difference in premiums between the purchase and sale prices can lead to a profit or loss. Also, investors must include any fees or commissions charged by their broker to buy or sell the contract.
LEAPS puts provide investors with a long-term hedge if they own the underlying stock. Put options gain in value as an underlying stock’s price declines, potentially offsetting the losses incurred for owning shares of the stock. In essence, the put can help cushion the blow of falling asset prices.
For example, an investor who owns shares of XYZ Inc. and wishes to hold them for the long term might be fearful that the stock price could fall. The investor could purchase LEAPS puts on XYZ to hedge against unfavorable moves in the long stock position. LEAPS puts help investors benefit from price declines without the need to short sell shares of the underlying stock.
Short selling involves borrowing shares from a broker and selling them with the expectation that the stock will continue to depreciate by expiry. At expiry, the shares are purchased—hopefully at a lower price—and the position is netted out for a gain or loss. However, short selling can be extremely risky if the stock price rises instead of falling, leading to significant losses.
As a review, a market index is a theoretical portfolio made up of several underlying assets that represent a market segment, industry, or other groups of securities. There are LEAPS available for equity indexes. Similar to the single equity LEAPS, index LEAPS allow investors to hedge and invest in indices such as the Standard & Poor’s 500 Index (S&P 500).
Index LEAPS give the holder the ability to track the entire stock market or specific industry sectors. Index LEAPS allow investors to take a bullish stance using call options or a bearish stance using put options. Investors could also hedge their portfolios against adverse market moves with index LEAPS puts.
Long timeframe allows selling of the option
Used to hedge a long-term holding or portfolio
Available for equity indices
Long time frame ties up the investment dollars
Markets or companies movements may be adverse
Real World Example of LEAPS
Let’s say an investor holds a portfolio of securities, which primarily includes the S&P 500 constituents. The investor believes there may be a market correction within the next two years. As a result, they purchase index LEAPS puts on the S&P 500 Index to hedge against adverse moves.
An investor buys a December 2021 LEAPS put option with a strike price 3,000 for the S&P 500 and pays $300 up front for the right to sell the index shares at 3,000 on the option’s expiration date.
If the index falls below 3,000 by expiry, the stock holdings in the portfolio will likely fall, but the LEAPS put will increase in value, helping to offset the loss in the portfolio. However, if the S&P rises, the LEAPS put option will expire worthlessly, and the investor would be out the $300 premium.
Perfect for Beginners!
Free Trading Education! Free Demo Acc!
Get Your Sign-up Bonus Now: