Long-term Equity Anticipation Securities (LEAPS) are trade options contracts that have a longer expiration timeframe than typical standard options. Unlike standard options which expire after a few months, LEAPS options have an expiry of more than one year to three years.
Investors often opt for LEAPS options with companies that they are bullish about, and that attract public interest. LEAPS options, like other standard options, are derivatives that draw their value from the assets. These assets may include indexes, foreign currencies, or stocks.
How Do Long-Term Equity Anticipation Securities Work?
LEAPS options support the acquisition of market shares across varied portfolios. It only supports the trade of option stocks and indexes that are listed in the Chicago Board Option Exchange (CBOE) list. This list is updated yearly in May, June, and July.
Investors purchase LEAPS options for the assets they desire. These options give investors the right to buy or sell those stocks (depending if it is put or call) on or before the expiration period. Once the maturity date elapses, the investor loses the right and obligation to make transactions on that asset.
LEAPS options can either be purchased from brokers or trading networks. Equity options for LEAPS expire yearly on the third Saturday of January. LEAPS do not support transactions after the contract period has elapsed.
What Are Long-term Equity Anticipation Securities Used for?
LEAPS options are preferred over standard options because of some of their peculiarities, including:
- It allows investors to expand their investment portfolios over different stocks or assets
- LEAPS allows investors to benefit from long-term price changes in stocks without making purchases upfront
- Lastly, it allows investors to hedge in their investments to avoid possible losses in the future
An Example of Long-term Equity Anticipation Securities (LEAPS)
Let’s assume that Mr. Smith owns shares with CYZ Corporation. He is afraid that those shares may decline in value over the next few years and he is not yet willing to sell those shares.
Mr. Smith could decide to purchase LEAPS put on CYZ Corporation to protect his investments in event of an unfavorable market in the future.
In another vein, let’s consider another investor, Mrs. Finley wants to purchase 10,000 shares from CYZ Cooperation at $12 per share. She accesses the market and believes that these shares will increase in the nearest future.
Rather than spend $120,000 to purchase the shares, she could decide to LEAPS call and buy 10 contracts instead. So, for each contract, she gets 1000 shares at a $4 premium price and a strike price of $15. Mrs Finley now pays $40,000 (4 × 10,000) as against $120,000.
If her predictions were right and the market value increases to $24, Mrs. Finley could decide to opt for a LEAPS call and buy the stocks at $12. She would then resell them at $24. This will give her a profit of $8 ($24 – $12 (cost price) – $4 (premium) for every share she sells.
But if she was wrong and the market value did not increase, rather than lose $120,000 in buying the whole stock, she would only lose $40,000 (her initial capital).
When Should You Buy LEAPS?
There are several criteria to guide you as an investor who wants to purchase LEAPS options.
- LEAPS options should generally be purchased for stocks with maturity dates of 367 days and above. Some people also consider options of 6 months and above as LEAPS options.
- LEAPS call options should be purchased when the market value (stock price) is higher than the strike price
- LEAPS put options should be purchased when the market value (stock price) is lower than the strike price
- Implied Volatility: The implied volatility margin for LEAPS options are fairly stable due to its long-term duration, unlike standard options. Hence, it is a negligible factor when considering LEAP option purchases
However, just like standard options, LEAPS options are also sensitive to changes in interest rate and option price.
How LEAPS Are Taxed?
Long-term Equity Anticipation Securities (LEAPS) options taxes are not duration-dependent. As long as an option is longer than a year, it is a LEAPS option, and the investor is taxed based on the long-term capital gain rate.
This means that if an investor subscribes to a LEAPS put option at the strike price and makes a profit, they will be taxed based on how long they owned the shares option regardless of the duration of the contract.
Types of Long-Term Equity Anticipation Securities (LEAPS)
There are two types of Long-term Equity Anticipation Securities.
- Calls, traditionally known as when an investor buys an option
- Puts, traditionally known as when an investor sells an option
Long-Term Equity Anticipation Security Puts
LEAPS puts refers to when an investor decides to sell his or her shares or assets on or before the end of the expiration. Put options are initiated at a value price that is lower than the market value. A LEAPS put option is said to be ‘in the money’ if the strike price is above the market value or stock price.
When the strike price of a LEAPS put option is below the market value, that option is said to be ‘out of the money’. When the strike price and market price are the same value, the option is said to be ‘at the money’. These terms help to identify the buyer’s option position in the market
Long-Term Equity Anticipation Security Calls
LEAPS calls are financial contracts that give owners the privilege to purchase LEAPS at the strike price. Like standard options, they give investors the right to buy a certain number of LEAPS on or before the given expiration period at the stipulated amount (strike price). Investors make LEAPS calls when the market value is higher than the strike price.
A LEAPS call option is said to be ‘in the money’ if the strike price is below the market value or stock price. When the strike price of a LEADS call option is above the market value, that option is said to be ‘out of the money’. When the strike price and market price are the same value, the option is said to be ‘at the money’.
Benefits & Disadvantages of Long-Term Equity Anticipation Securities
Since its inception in 1990 by the Chicago Board Options Exchange (CBOE), LEAPS have become very popular trade options. Every new investor needs to get familiar with the pros and cons surrounding the LEAPS option.
Disadvantage of LEAPS
- The initial premium for LEAPS options is more expensive when compared to other short-term options
- LEAPS poses higher risks due to the prolonged expiration period
- The prices of LEAPS options are more sensitive to changes in interest rate and implied volatility
Advantages of LEAPS
- Due to the prolonged expiration period, LEAPS have a higher delta value
- It provides less liquidity
- It is available for stocks or equity indices
- There is a higher potential to make more money if risks are handled well
- It provides benefits to hedge in the stock market for a longer period
Long-Term Equity Anticipation Securities (LEAPS) vs. Shorter-Term Contracts
Both the Long-term Equity Anticipation Securities (LEAPS) and other short-term contracts are options that investors can bid into. However, one’s preference between the two options will depend on the risk profile as well as available capital.
LEAPS help investors access long-term options without the need to accumulate numerous short-term option contracts. With LEAPS, investors who want to buy options of more than 1 year can simply purchase a 2 or 3-year option and enjoy the same securities over a long period.
This would be more preferable to buying a 1-year option and renewing it yearly. Also, investors can choose to sell the assets anytime within the maturity time frame.
Long-Term Equity Anticipation Securities (LEAPS) vs. Stocks
The longer maturity time (expiration) of LEAPS provides an advantage over buying stocks. You can buy LEAPS instead of stocks, or use LEAPS as hedges for the stocks you already have.
For instance, if you predict a rise in a particular stock price, you can buy a LEAPS option for that stock instead of buying the stock. You will benefit from the long-term expiration as well as from the marginal delta that the LEAPS option provides.
The purchase of LEAPS is also less expensive and requires smaller capital than buying stocks. Additionally, it allows you to earn from price fluctuations in stocks.
With regular options, the bid/ask spread is narrow, which amounts to little gain. LEAPS options bid spread over wider margins and led it to even more profit.
LEAPS options are a risky, complex yet lucrative investment. Without proper guidelines, you stand the risk of loss in your investment capital. They are also not as straightforward as standard options. You can reduce your risk by seeking the help of financial advisors.
Financial advisors help you navigate the complex taxing system of LEAPS options. They also help you understand the types of strikes to look out for when you want to purchase LEAPS. With the help of a financial advisor, you can track your returns from different investments and learn how to roll options forward.
As a rule of thumb, LEAPS options are most profitable for investors who have a lot of cash to spare, can take huge risks, bear great losses, and enjoy strategic trading.