Leaps

What Are LEAPS?

LEAPS, an acronym for Long-Term Equity AnticiPation Securities, are a type of exchange-traded options contract with an unusually long expiration date. Unlike standard options that typically expire within a year, LEAPS can have expiration dates up to two or three years into the future. They fall under the broader category of derivatives, as their value is derived from an underlying asset, such as a stock or an index. LEAPS offer investors a way to express a long-term directional view on an asset while potentially requiring less capital than owning the asset outright. Both call options and put options are available as LEAPS.

History and Origin

The concept of standardized, exchange-traded options emerged in 1973 with the establishment of the Chicago Board Options Exchange (Cboe). Prior to this, options trading was largely conducted over-the-counter with unstandardized terms. To cater to investor demand for longer-term exposure, Cboe introduced LEAPS in 1990. This innovation allowed market participants to take extended positions without needing to continually roll over shorter-term contracts, fundamentally changing how some investors approached long-term speculation and hedging strategies. LEAPS have since become a common instrument listed across U.S. options exchanges⁴.

Key Takeaways

• LEAPS are options contracts with longer expiration periods, typically up to two or three years.
• They are available as both call and put options on individual equities and major market indices.
• LEAPS can be used for long-term speculation on an underlying asset's price movement or for hedging existing portfolio positions.
• While their premium is generally higher than shorter-term options, it is typically lower than the cost of purchasing the equivalent number of shares of the underlying stock.
• The extended timeframe of LEAPS reduces the impact of short-term volatility and time decay, offering a different risk/reward profile.

Interpreting the LEAPS

Interpreting LEAPS involves understanding how their long expiration period influences their pricing and potential use cases. Because of the extended time until expiration, LEAPS premiums tend to be higher than those for conventional options with shorter terms. This is due to the greater probability of the underlying asset moving favorably over a longer duration. When evaluating LEAPS, investors should consider the implied volatility of the underlying asset, as well as the chosen strike price relative to the current market price. An in-the-money LEAPS will have a higher intrinsic value and offer a more direct proxy for the underlying asset's movement, while out-of-the-money LEAPS offer greater leverage but carry higher risk.

Hypothetical Example

Consider an investor, Sarah, who believes that Company X's stock, currently trading at $100 per share, will experience significant growth over the next two years. Instead of buying 100 shares for $10,000, Sarah decides to purchase a LEAPS call option with a strike price of $105 and an expiration date two years out. The premium for this LEAPS contract is $10 per share, totaling $1,000 for one contract (representing 100 shares).

If, in 18 months, Company X's stock rises to $130, Sarah's LEAPS contract is now deeply in the money. She could sell the LEAPS for its current market value, which would include significant intrinsic value and still some extrinsic value. Alternatively, she could exercise the option, purchasing 100 shares at $105 each and immediately selling them at the market price of $130, realizing a profit before deducting the initial premium and commissions. This strategy allows Sarah to benefit from the stock's appreciation with a smaller initial capital outlay compared to buying the shares directly.

Practical Applications

LEAPS offer various practical applications within portfolio management and investment strategies. One primary use is for long-term directional exposure. Investors can utilize LEAPS call options to participate in the potential upside of a stock or index over several years, using less capital than purchasing the actual shares. This can free up capital for other investments, enhancing diversification. Conversely, LEAPS put options are frequently employed as a long-term hedging tool to protect an existing portfolio from substantial market downturns³. By holding LEAPS puts on a stock or an index, an investor can mitigate significant losses without selling their underlying holdings. Additionally, LEAPS are used in strategies like covered calls or protective puts, offering income generation or downside protection for long-term stock positions. Rules governing options trading, including those for LEAPS, are established by regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) to ensure fair and orderly markets².

Limitations and Criticisms

Despite their advantages, LEAPS come with inherent limitations and criticisms that investors should consider. Like all options, LEAPS contracts can expire worthless if the underlying asset does not move as anticipated or if the price movement is insufficient to cover the initial premium. While the extended time frame mitigates the rapid time decay seen in short-term options, LEAPS still experience erosion of extrinsic value as their expiration date approaches. Furthermore, the leverage offered by LEAPS, while a benefit, also amplifies losses; an adverse movement in the underlying asset can lead to a total loss of the premium paid. Critics often point to the speculative nature of derivatives, highlighting that a significant percentage of retail investors engaged in options trading, particularly in markets with high derivatives volumes, experience losses¹. Investors must also be aware of margin requirements associated with writing (selling) LEAPS, as these can be substantial and lead to significant losses if not managed carefully.

LEAPS vs. Standard Options

The primary distinction between LEAPS and standard options lies in their expiration date. Standard options typically have expiration periods ranging from one week to up to 12 months. LEAPS, on the other hand, are specifically designed for long-term positions, offering expiration dates that can extend as far as two to three years into the future.

This difference in duration has significant implications for their characteristics and usage:

The longer timeframe of LEAPS makes them less susceptible to the immediate fluctuations and rapid time decay that characterize shorter-term options, making them a distinct tool for investors with a protracted market outlook.

FAQs

What assets can LEAPS be traded on?

LEAPS can be traded on various underlying asset types, including individual stocks (known as equity options) and broad market indices (known as index options). Some common examples include LEAPS on popular companies and major stock market indices.

Are LEAPS riskier than stocks?

LEAPS offer leverage, meaning a small price movement in the underlying asset can lead to a larger percentage gain or loss in the LEAPS contract. While this leverage can amplify profits, it also amplifies losses, potentially leading to the total loss of the premium paid. In this sense, they can be riskier than directly owning shares, as stocks typically do not lose 100% of their value unless the company goes bankrupt.

Can LEAPS be sold before expiration?

Yes, LEAPS, like other exchange-traded options, are liquid instruments and can be bought and sold at any time before their expiration date in the open market. Investors do not have to hold them until expiration to realize gains or cut losses.