LEAPS: How Long-Term Equity Anticipation Securities Options Work

What Are Long-Term Equity Anticipation Securities (LEAPS)?

Long-term equity anticipation securities (LEAPS) are options contracts with expiration dates extending beyond one year, often up to three years. These contracts allow investors to gain exposure to long-term price movements in the underlying asset, similar to standard options but with extended expiration periods. A LEAPS contract provides the buyer the right, but not the obligation, to buy or sell the underlying asset at a predetermined price, depending on whether the option is a call or a put.

Key Takeaways

Long-Term Equity Anticipation Securities (LEAPS) are options contracts that expire beyond one year, providing investors the chance to capitalize on long-term market movements.
LEAPS can be used as a strategic hedge against potential market declines or as a speculative bet on expected price increases, offering flexibility to investors.
While offering the potential for significant profit, LEAPS come with higher premiums than short-term options and involve risks, including the possibility of losing the premium if the option expires worthless.
Index LEAPS allow investors to hedge entire portfolios against adverse movements in market indices such as the S&P 500, thus providing broad market exposure or protection.
Introduced by the Cboe in 1990, LEAPS have become a staple in options trading, but investors should be aware of their higher costs and the potential for substantial losses if market conditions shift unfavorably.

Deep Dive into LEAPS: Understanding Their Structure and Benefits

LEAPS are no different from short-term options, except for the later expiration dates. Longer maturities let long-term investors capitalize on extended price movements. Like short-term options, investors pay a premium to buy or sell at an option's strike price, the predetermined price to execute the contract at expiration.

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. Each put or call option represents 100 shares of the underlying asset.

Investors must understand that they will be tying up funds in these long-term contracts. Market interest rate and asset volatility changes can affect the value of these options, depending on their movement direction.

Leveraging Index LEAPS for Strategic Market Exposure

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 stock LEAPS, index LEAPS allow investors to hedge and invest in indices such as the Standard & Poor's 500 Index (S&P 500).

Index LEAPS allow holders to track the stock market or certain sectors, taking a bullish position with calls or a bearish stance with puts. Investors could also hedge their portfolios against adverse market moves with index LEAPS puts.

Decoding LEAPS Premiums: Costs, Value, and Influencing Factors

Premiums are the non-refundable cost of an options contract. LEAPS premiums are higher because longer expiration dates offer more time for asset movement and potential profit. This timeframe, called time value, along with intrinsic value, helps determine an option's overall value.

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 Meta (META), formerly Facebook, 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.

Fast Fact

LEAPS were first introduced by the Cboe in 1990, and are now ubiquitous.

Comparing LEAPS and Short-Term Options: Key Differences

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.

This process, which is 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 provides the longer-term trader with exposure to a prolonged trend in a particular security with one trade.

Exploring the Different Types of LEAPS: Calls and Puts

Calls

Equity LEAPS call options allow 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. Profit or loss depends on the premium difference between purchase and sale. Investors should also consider brokerage fees and commissions.

Puts

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 Company XYZ and wishes to hold them for the long term might be fearful that the stock price could fall. To allay these concerns, 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 means borrowing and selling shares, expecting prices to drop by expiry, then buying them back at lower prices, resulting in a gain or loss. However, short selling can be extremely risky if the stock price rises instead of falls, leading to significant losses.

Weighing the Pros and Cons of LEAPS Investment

There are several key benefits and drawbacks of investing in long-term equity anticipation securities. We've listed some of the main ones below.

Advantages

The long timeframe of a LEAPS contract allows you to sell the option.
You can use a LEAPS contract to hedge your bets against fluctuations in your overall long-term portfolio.
There are plenty of LEAPS options available for investors who want to invest in equity indices, which means that you can hedge your bets against any drastic moves in the market. And by doing so, you can also take a bearish or bullish stance on the market as a whole rather than individual equities.
The prices for LEAPS are not as sensitive to the movement of the underlying asset. If the underlying asset's price changes, the price for the contract won't necessarily make a big move itself.

Disadvantages

The premiums for LEAPS are much costlier than other types of investments.
Because you're investing your money for the long term, your money is tied and locked up for the duration of the contract. This means that if you find another great investment opportunity, you may not be able to take advantage of it.
You may be susceptible to adverse movements in the market or individual companies, which can affect your overall position.
The prices for LEAPS are highly sensitive and subject to market volatility and interest rate fluctuations.

Pros and Cons of LEAPS

Pros

Long time frame allows selling of the option
Used to hedge a long-term holding or portfolio
Available for equity indices
Prices less sensitive to the movement of the underlying

Cons

Costlier premiums
Long time frame ties up the investment dollars
Markets or company movements may be adverse
Prices more sensitive to changes in volatility and interest rates

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 and, as a result, purchases index LEAPS puts on the S&P 500 Index to hedge against adverse moves.

The investor buys a December 2021 LEAPS put option with a strike price of 3,000 for the S&P 500 and pays $300 upfront 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 500 rises, the LEAPS put option will expire worthless, and the investor would be out the $300 premium.

Are LEAPS a Good Investment?

LEAPS are simply long-date call or put options listed on stocks or indexes. As such, they will have higher initial premiums than shorter-dated options and lose value over time, all else equal. Like any investment, LEAPS will change in value - in the case of a call, it will rise and fall along with the underlying security (and for a put, inversely). For some investors, LEAPS may provide a more affordable way to take a long position than purchasing the actual stock.

When Should You Buy LEAPS?

If you have a medium-term time horizon, then a LEAPS call may be a good speculative bet on a stock that you think will rise. You can also buy LEAPS puts as a medium-term downside hedge against existing positions.

Can You Lose Money With LEAPS?

Yes, LEAPS involve risk and you can lose up to your full investment when purchasing one if it ultimately expires worthless. Selling LEAPS is also risky as you are exposed to theoretically unlimited losses if the underlying security moves against you.

Do You Pay Taxes on LEAPS?

Yes, when LEAPS are sold at a profit, the gain is taxable. If the LEAP contract was held for at least one year and one day, the taxpayer will be taxed at the long-term capital gain rate. If the contract was held for shorter, the taxpayer will be taxed at a short-term capital gain rate.

What Is the Downside of LEAPS?

There are several specific downsides to LEAPS. Most often, investors that buy LEAPS must put up more capital upfront at the beginning of the contract to pay for the initial premium. In addition, because they have more time until expiration, LEAPS often cost more than traditional options.

The Bottom Line

Launched in 1990 by the Chicago Board Options Exchange (CBOE) to meet investor demand, LEAPS are now a mainstay of options trading. LEAPS, which stand for Long-Term Equity Anticipation Securities, are simply listed equity call and put options that have initial expiration dates that are greater than one year, and up to 39 months into the future. As with all options, LEAPS have unique risks, so investors must understand the potential risks and rewards.