LEAPS and bounds

Leap year has nothing to do with LEAPS. But it’s never a bad time to learn about the potential benefits of long-term equity anticipation securities, commonly known as LEAPS. These long-dated options may come in handy for long-term investors and traders alike.

In contrast to “regular” options, which usually expire within 6 months or so, LEAPS are options with expirations as far out as 3 years. Because they have more time until expiration, LEAPS cost more than traditional options. The longer you have until expiration, the greater the probability that the option can be in the money, and so this type of option is more expensive.

There are a couple of other relevant and significant characteristics of LEAPS. If the underlying asset pays a dividend, the owner of a LEAPS call does not receive it. Also, LEAPS owners do not have voting rights.

Why use LEAPS?

LEAPS behave in a similar manner to shorter-term options, but with the added feature of a longer time until expiration. The greater time until expiration can provide long-term investors with another tool that allows them to position their portfolio as they see fit, instead of buying a stock or another security outright.

Here are a few strategic uses of LEAPS for long-term investors.

Buying LEAPS calls allows you to benefit from a potential increase in a stock or index over the course of a few years. Assume you believe a stock will go up in price over the next couple of years. Instead of purchasing the stock outright, you might want to buy a 2-year LEAPS option. Here’s why:

1. Options can enhance return. LEAPS allow you to control a greater number of shares with a smaller amount of money. Note that, as with regular options contracts, there is risk associated with employing options as a way to leverage up your returns.
2. The potential loss of the trade may be reduced.The maximum potential loss of purchasing LEAPS is the cost of the option, whereas the maximum potential loss on purchased stock is that it could hypothetically go to zero. While it is important to recognize that the likelihood of LEAPS expiring worthless is more probable than a stock going to zero, you may be able to put less capital at risk because options allow you to control a greater number of shares with a smaller amount of money.

These benefits might make LEAPS a potentially attractive choice for stock investors who would not normally purchase options.

Buying LEAPS puts can also help hedge against a substantial decline in a stock or index over time. Suppose you have been accumulating stocks, and they have appreciated in value. You are now concerned that the market will go down over an extended period of time, but you aren’t sure when it will begin to decline and do not want to sell your stocks prematurely. Buying protective LEAPS puts can help you hedge against a potential decrease in the stocks you own over an extended period of time.

With a protective put, you own the underlying stock and you purchase a put option. So, if you own stock that has gone up in value, the purchased put essentially locks in some of the unrealized profit, less the cost of the put option. For example, suppose you purchased 100 shares of ABC at $50 per share. Several months later, the stock is now trading at $65 per share. If you are bullish about the stock long term, but you have become concerned about the stock over the intermediate term (perhaps due to an expected slowdown in earnings over the next few quarters), you might consider a protective put to lock in the gains the stock has made.

This could be done, for instance, by purchasing one ABC one year 60 put LEAP at $5. If the stock were to rise to $70, the put would expire worthless, resulting in a loss of $5, (the cost of the option). The total profit, if you sold the stock, would be $15 ($20 capital gain minus $5 option price), less any commissions and fees. Alternatively, if the stock fell to $50, you could exercise the option for a profit of $5 ($60 put price minus the $50 underlying price, minus the $5 option premium), less any commissions.

Recalling the assumption that you expect the market to fall for an extended period of time, using LEAPS , instead of options with shorter time until expiration, allows you to hedge against a potential decline over a longer period of time, less the cost of the option.

Active LEAPS strategies

Active traders can benefit from LEAPS as well. LEAPS might be used by traders who would like to take a longer-term position in some of the same shorter-term options they currently trade.

For example, assume that you believe XYZ company will report disappointing earnings in the upcoming quarter, so you decide to purchase a put option. A few days later, news emerges that makes you very positive on the long-term prospects of the company. You still expect there to be some short-term problems in the earnings report, so you don’t want to close out the put option position. One strategy could be to purchase a 3-year LEAPS call to benefit from your expectation that the company will do well over the longer-term period. This allows you to maintain your short-term bearish trade and enter into a bullish long-term position.

LEAPS can also be used in advanced options strategies as well, such as a bull call spread, calendar spreads, and collars.

Other investing implications

In addition to their use in advanced options strategies, you might be able to get creative with LEAPS, depending on how well you are able to manage risk.

For example, to take advantage of others’ expectation for high volatility, it might be possible to sell deep out-of-the-money LEAPS puts on stocks that are more sensitive to fluctuations in the business cycle.

One reason for using LEAPS here would be that others who expect higher volatility might be willing to pay for such an expensive option, and so you could take in a relatively high premium (due to the longer-time to expiration and increased expected volatility features). Because the options are far away from a strike price at which they could be exercised, there might be a greater probability that the option will expire worthless and you’ll get to keep the premium. Of course, this assumes that volatility does not go against you, resulting in the stock price dropping far enough so that option might be exercised, thereby potentially incurring significant losses.

As you can see, there are a number of uses for LEAPS. If your trading or investing strategy could benefit from long-term options, consider LEAPS.