LEAPS: How Long-Term Equity Anticipation Securities Options Work

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

LEAPS, or long-term equity anticipation securities, are publicly traded options contracts with expiration dates that are longer than one year. Typically, LEAPS may expire up to three years from the date of issue. They are functionally identical to most other listed options, except with longer times until expiration.

A LEAPS contract grants a buyer the right, but not the obligation, to purchase or sell (depending on if the option is a call or a put, respectively) the underlying asset at the predetermined price on or before its expiration date.

Understanding Long-Term Equity Anticipation Securities (LEAPS)

LEAPS 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 or 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 put or call options contract equates to 100 shares of the underlying asset.

Investors 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.

Index LEAPS

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 give the holder the ability to track the entire stock market or specific industry sectors and 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.

LEAPS Premiums

Premiums are the non-refundable cost associated with an options contract. The premiums for LEAPS are higher than those for standard options in the same stock because 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 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.

Long-Term Equity Anticipation Securities vs. Shorter-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.

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.

Types of LEAPS

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. The difference in premiums between the purchase and sale prices can lead to a profit or loss. Investors must also include any fees or commissions charged by their broker to buy or sell the contract.

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 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.

Advantages and Disadvantages of LEAPS

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.

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.

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 come with unique risks and investors should understand the potential risks and rewards of trading in them.