LEAPS stands for long-term equity anticipation securities and can be a powerful tool for long-term investors. LEAPS differs from traditional options contracts in that expiration dates are longer than a year, sometimes stretching to three years. However, like traditional options, LEAPS options still grant the buyer the right (not the obligation) to buy or sell the underlying asset at a specific strike price on or before the expiration date. They are ideal for traders who want to take advantage of prolonged trends and are often used in hedging strategies and for additional protection in retirement portfolios.
Our guide on LEAPS options will address how they work, their benefits, and strategies for using them effectively. Something essential to know about LEAPS options is that the premiums are higher than standard options in the same stock but lower than the cost of shares of the underlying stock. Anything you want to know about LEAPS options will be addressed in this guide, and you can learn how to work them into your investment strategy!
What Are LEAPS?
LEAPS options are basically the same as traditional options except for a much lengthier expiration cycle. Most options expire in under a year, while LEAPS options range from one to three years. As we dive deeper into this guide, you’ll learn how inventors and traders can benefit from this extended period.
Definition of LEAPS
LEAPS stands for long-term equity anticipation securities. These options contracts give the buyer the right to buy or sell underlying assets at a specific strike price and by a particular expiration day. LEAPS differs from regular options contracts because they have a longer expiration date overall, with some going out as long as three years. In many cases, LEAPS expire a year from the entry date.
LEAPS is better for traders who want to make long-term bets on stocks, protect their retirement portfolios, or use hedging strategies effectively. Traders can find LEAPS options on futures exchanges. They’re listed on stocks or indices. One LEAPS contract represents 100 shares of an underlying stock.
Key Characteristics of LEAPS
- LEAP options are longer than regular options, typically 1-3 years. If the expiration date is less than a year away, you’re most likely dealing with a standard options contract.
- LEAPS options are available for many stocks and indices.
- Buying LEAP options doesn’t give you ownership of the company but gives you the right to buy or sell the stock at a set price.
How Do LEAPS Options Work?
The basic idea behind a LEAPS option is that the lengthier time until the expiration date allows exposure to prolonged price movements. Investors end up tying up some of their capital in LEAPS options, and the options can become more or less valuable depending on changes in interest rates, market/asset volatility, the holding itself, or the direction of the market movement.
Call vs. Put LEAPS
LEAPS comes in two types: calls and puts. With call LEAPS, buyers can buy the security at a specific strike price before expiration. These calls are exercised when the strike price is lower than the market value. Conversely, LEAPS gives buyers the right to sell the security at a specific strike price before expiration. These puts are exercised when the strike price exceeds the market value.
Call options with equity LEAPS help investors benefit from potential rises in the stock price. However, they can use much less capital than purchasing shares upfront while using cash (the cost of the premium is much lower for the investor than it would be to buy the 100 shares with cash). Call LEAPS is advantageous because it lets the investor or trader sell the contract at any point before the expiration date kicks in.
Put options with equity LEAPS are advantageous because they provide a long-term hedge for investors who own the underlying stock. As the underlying stock declines, put options increase in value, ultimately offsetting the losses one would face from owning shares in the stock.
LEAPS Expiration Dates
LEAPS are best for investors and traders who have extensive experience, are financially stable, and can afford to invest a lot of capital. They take longer to play out than shorter-term options, which means that they aren’t as susceptible to the negative effects of time decay.
LEAPS options are exercised if the expiration date arrives and the option is in-the-money (ITM). Call LEAPS are exercised when the market price is higher than the strike price, and put LEAPS are exercised when the market price is lower than the strike price.
Understanding Strike Prices
On LEAPS call options, it’s best to choose strike prices higher than the current stock price. This approach is best for investors who believe the stock will rise long-term. Think about the market outlook. If you’re feeling bullish about an investment, it’s best to use a call LEAPS option. Consider using a strike price interval where you set the strike within 25% above or below the underlying stock’s price.
Why Use LEAPS in Long-Term Investing?
LEAPS can be suitable for long-term investing because it allows investors to benefit from stock price rises and lets them risk less capital than needed to buy the stock. Let’s look at how investors can leverage with lower risk, hedge portfolio risk, and enjoy the strategic advantage of flexibility.
Leverage with Lower Risk
Investors using LEAPS options can benefit from stock price increases, giving them the right to purchase the underlying stock at a specified price. Traders use less capital by paying the premium on the stock instead of outright using cash to buy 100 shares. Not only are you getting a deal on an underlying stock, but you can benefit any time the market moves favorably in your direction and the stock price increases.
Hedging Portfolio Risks
As discussed earlier, put LEAPS can be used to hedge against downturns in existing long-term investments. To hedge investments using LEAPS, investors must buy put contracts, which give them the right to sell their shares at a specific strike price before the long expiration date arrives. Investors can benefit from upsides in the stock price minus the cost of the put option. The ultimate result is an investor’s losses being limited to the premium paid on the put.
LEAPS are ideal for a long-term hedge because these contracts have an expiration cycle of a year or longer. Put options gain value as the price of the underlying stock declines, resulting in offset losses. There are a few drawbacks to using LEAPS as a hedge:
- Higher premiums than short-term options
- No dividend payments
- Time decay sets in as the option closes in on the expiration date
- LEAPS options aren’t as liquid as short-term options (they’re harder to buy or sell)
Flexibility and Strategic Advantage
The ability to hold LEAPS longer than standard options allows for more flexibility. This means that LEAPS options can fit into a variety of investment strategies like hedging investments, taking advantage of stock price increases, and increasing your portfolio’s overall returns.
- Increase Returns—Sell LEAP-covered calls to maximize returns on the underlying stock. At the same time, you can provide your investments with some downside protection.
- Stock Price Increases—Risk less capital than needed by paying the premium on the underlying stock instead of buying 100 shares in cash. You still benefit from any stock price increases in the meantime.
- Hedge Your Investments—LEAPS options allow investors and traders to protect themselves against stock price declines. This specifically applies to stocks that the investors own long-term.
Benefits of Using LEAPS
If using LEAPS options weren’t beneficial, we wouldn’t be presenting this guide to our readers! Obviously, there are many ways to benefit from this trading strategy, and we’ve outlined the main reasons below why you might want to begin implementing it into your trading routine, especially if you have the capital to hold these investments over a longer period of time.
Reduced Cost Compared to Buying Shares
LEAPS options offer a cost-efficient way to gain exposure to stocks. We mentioned earlier that call LEAPS has cheaper premiums than buying 100 shares outright with cash. Essentially, you’re controlling a larger number of shares for a smaller cost, which can increase your overall returns, though the potential losses can become more critical, too.
Potential for Higher Returns
Because there are fewer initial capital requirements, trading LEAPS options can give investors the potential for higher returns. LEAPS are popular with investors with the capital to back them up because these investments have an advantageous timeline. They can be used to diversify their portfolios or even set aside some capital for emergency investments or other assets.
Longer Timeframe to Execute Strategies
The longer expiration cycle that the LEAPS options give to investors allows the time necessary for the market to move in a favorable direction toward the investor. Whereas short-term options are more negatively impacted by time decay, and there’s much less time for the stock to perform how the trader expects it to, LEAPS options give traders at least a year to capitalize on positive long-term trends. This gives them the time to execute appropriate strategies like hedging, benefiting from stock price increases, and maximizing their returns.
Risks of Using LEAPS
While there are multiple benefits to working LEAPS options into your trading strategy, you run into some risks, too, that can negatively affect your portfolio and investments if you aren’t careful with how you implement this technique. In some cases, like an unfavorable market movement, there is nothing you can do about it, but there are some risks that you can prevent, like managing time decay and liquidity.
Time Decay
Even though there’s much more time until expiration with LEAPS options, these options are still susceptible to time decay, especially in the last 60 days of the contract. The more in-the-money the option is, the more significant the effect of time decay on that contract. In fact, as a LEAPS option gets closer to expiration, it begins behaving more like a short-term option contract when it comes to time decay. You benefit significantly initially with LEAPS options, but they quickly lose their value toward the end, so it’s something to keep in mind.
The benefit of LEAPS options contracts is that the trader can sell them at any point before the expiration cycle, so it’s beneficial to get out before the last 60 days set in, if not earlier. LEAPS benefits traders with the capital to invest in these long-term positions: There’s ample time for the market to move favorably and a considerable window to exit the trade before it goes south.
Leverage Risks
As with many other types of investments, LEAPS are subject to leverage risks. This is where leveraging results in a loss if financing costs exceed the income from the asset or if the asset’s value falls off. Investing in debt and losing what you borrowed has the potential to wipe out any profits you might have made.
The potential for these losses occurs if the market moves unfavorably. There isn’t much you can do about the market moving against you, but there are several ways to manage level risks:
– Set up a conservative position size (no more than 1-2% of your capital)
– Use stop-loss orders to limit potential losses
– Compared the potential loss to the potential gain on each trade (risk-to-reward ratio)
– Practice LEAPS using demo accounts (if possible)
– Adjust your leverage levels as needed based on market conditions
– Spread your investments across multiple asset classes and sectors
Limited Liquidity
LEAPS options have limited liquidity compared to short-term options contracts. Liquidity refers to how quickly and easily an option can be bought or sold. Because they cost more than short-term options contracts, LEAPS can be harder to buy and sell, which means they have limited liquidity—they can be difficult to sell off, especially when the time decay factor becomes more pronounced in the last 60 days before the expiration date.
If an investor wants to eliminate a LEAPS option, they’ll have a more challenging time than a short-term options contract. When the expiration date is drawing nearer and time decay begins deteriorating the stock’s value, increased market volatility can save the trade to an extent by temporarily increasing the value of the stock. Hence, traders have enough time to get rid of it before it expires as worthless.
Strategies for Using LEAPS in Long-Term Investing
Now that you know what LEAPS options are, why you should use them in trading, and the primary benefits and risks associated with the technique, what are some of the best strategies for using LEAPS for long-term investments? This section of the guide will go over bullish and bearish strategies, plus using LEAPS as a substitute for stocks.
Bullish Strategy: Buying Call LEAPS
Use the LEAPS call to capitalize on long-term bullish trends. Start by choosing a stock that you like, but first, check its fundamentals and do some basic research to see if it’s right for your personal trading strategy.
When setting up the strike price on a call LEAP, choose a price that’s below the current stock price (a delete of at least 0.80). This type of strike price is known as “in-the-money.” Next, send a buy-to-open (BTO) order to your brokerage account. You can request the asking price or a price you’re willing to pay, also known as the limit order.
Bearish Strategy: Buying Put LEAPS
Investors and traders can use put LEAPS to protect against downside risk. This is best when the investor is concerned about a potential price drop on the stock they own (a bearish outlook on the market). The put is a great way to cushion the blow that comes from an asset’s price falling significantly.
LEAPS as a Substitute for Stocks
LEAPS calls can help investors control more shares with less money, and they benefit greatly from a potential increase in the stock’s price over a year or more. If you want to benefit from these potential stock price increases, it can become preferable to purchase LEAPS contracts instead of shares.
Another scenario where you’ll want to consider buying LEAPS instead of shares is if you want to hedge against a potential decline in the stock’s price. You can do it without short-selling shares of the underlying stock. LEAPS are also better to invest in than traditional options contracts if you’re looking to be more cost-effective, as premiums are cheaper than buying 100 shares of stock with cash.
Covered Call Strategy Using LEAPS
Traders can use in-the-money LEAPS to simulate the experience of stock ownership while also putting up less capital in the process. Instead of writing a covered call using a short-term option, you can write one using a LEAPS call where you own the underlying stock. This strategy helps generate income from the premium. It allows for downside protection along with long-term bullish positioning.
Hedging Strategy with Put LEAPS
Investors and traders can also use put LEAPS to hedge an existing portfolio against downturns. Not only can investors purchase a put LEAPS option to insulate themselves from a stock price decline, but they can also use the same put to profit from a potential stock price decline. This helps them out no matter what the outcome.
How to Choose the Right LEAPS for Your Strategy
The right LEAPS strategy will look different for each investor. It’s dependent on how open you are to risk in trading, how much capital you have to allocate to a LEAPS options contract, and which direction you feel the market will move on these particular investments (bearish or bullish outlooks). Let’s review the primary factors to consider when choosing LEAPS options contracts and how analysis tools can help with the process.
Factors to Consider
Traders and investors must consider a few factors when choosing the best LEAPS options for their trading strategy.
- Expiration Date—With LEAPS, investors must choose a strike price of at least one year, but they can go as high as three years. Remember that the longer the time until the contract matures, the higher the price, and this capital will be locked in for a long-term investment. It’s up to each investor to choose the timeframe that best suits their trading approach and investment budget.
- Strike Price—If you’re an investor who would rather play it safe regarding risk, you might consider choosing a strike price at or below the current stock price. Conversely, investors with a higher risk tolerance will want to select a strike price above the current market price.
- Volatility—If implied volatility moves higher, the extrinsic value of the LEAPS will increase. This means that traders purchasing LEAPS during times of high volatility might end up overpaying in extrinsic value. It’s best to get into LEAPS options strategies when the markets are relatively stable or when volatility is low, the reason being not overpaying for the investment.
- Liquidity—LEAPS aren’t as liquid as standard, short-term options, so the longer the LEAP, the less liquid they are. This can result in wider bid-ask spreads, increasing the overall expense of entering and exiting positions. Just as LEAPS with longer expirations cost more to enter, they also cost more to exit, and they can be harder to get out of.
Choosing Between Different Underlying Stocks or Indices
Stock volatility is an important factor when choosing between underlying stocks and indices. Long-term contracts like LEAPS benefit greatly from implied volatility right before expiration, but easing volatility before expiration can cause the price of the long contract to fall. On the other hand, implied volatility can negatively affect the option’s premium.
Index LEAPS are traded in industry and international sectors. They work just like other index options except for the longer expiration cycle. Index LEAPS can only be exercised on the last business day before expiration. All settlements come in the form of cash.
Using Analysis Tools
Traders and investors must implement technical and fundamental analysis into the LEAPS trading process to help them make important investment decisions.
- Fundamental Analysis—This assesses the intrinsic value of the company you’re investing in beyond what its stock prices show. It considers future growth, financial health, company earnings, and dividends. If the intrinsic value of a stock is higher than the current market price, this could signify a buying opportunity for investors.
- Technical Analysis—On the other hand, technical analysis is rooted in the idea that everything you need to know about the trade is in the stock price, regardless of the factors that go into determining a stock’s intrinsic value. Technical analysis is where an investor spots trends in the price movement and trading patterns that hopefully predict future stock movements. Technical analysis is done through tools like price charts and historical data.
When trading LEAPS options, it’s best to use both technical and fundamental analysis to inform your decision. Relying too heavily on one or the other could cause you to make a big mistake in structuring your strategy.
Pros and Cons of Investing with LEAPS
Our guide on LEAPS options has already covered the great benefits and risks of using LEAPS as a trading tool, but if you are skimming our guide, we’ve outlined this strategy’s main pros and cons below for your convenience.
Pros
- Better leverage
- Lower capital requirement (they cost less than the underlying asset)
- Flexibility to use with other strategies
- Potential for high returns
- The longer timeframe helps LEAPS not to deteriorate as much from time decay
- The value of LEAPS options more closely mirrors the underlying asset
- Use LEAPS on stocks or indices
- Take a bearish or bullish stance on the market instead of an individual equity (LEAPS indices)
- Price changes to the underlying asset don’t affect the contract’s price too drastically
Cons
- Costlier premiums compared to short-term stocks
- Risk of time decay (especially in the last 60)
- Potential losses due to leveraged risk
- The risk of limited liquidity for these long-term positions
- An investor has to tie up a lot of capital to execute a LEAPS strategy
- Market or company movements might be adverse
- LEAPS prices are most susceptible to interest rates and volatility
There are more advantages to using LEAPS than not using them. They’re enticing for many traders because they promise much higher returns. Still, there’s a significant capital commitment due to the higher premiums and the capital tied in with the longer timeframe that comes with the LEAPS option.
Common Mistakes to Avoid When Investing in LEAPS
Trading with LEAPS options might require more capital than usual, but once they’re set up, investors can get too comfortable with all the time the contract has. They can make significant mistakes with these investments if they aren’t careful. Avoid these common mistakes, and don’t let a LEAPS options contract end up biting you in the end. Carefully consider your strike price and expiration dates, don’t overleverage using this strategy, and keep a close eye on your investment to ensure time decay doesn’t erode your profits.
Overleveraging
Buying too many LEAPS can be risky because the premiums cost more, and your money is locked into this investment for a longer period to see gains. With much of your money invested in LEAPS options, more of your money is at risk if there’s an unfavorable market movement or the underlying security declines, triggering a much more significant percentage loss than the stock owners themselves.
Ignoring Time Decay
Time decay can eat away at profits if not managed, even with a LEAPS options contract, which has a lot more time. Keeping a close eye on the contract once it is about sixty days from the expiration date is essential. Time decay affects these contracts the most during this timeframe, and the LEAPS contract behaves more like a short-term options contract.
Choosing the Wrong Strike Price or Expiration
Choosing the wrong strike price can result in an investor losing their entire premium. The risk of this happening increases significantly if the strike price is further out of the money. Your strike price should reflect your personal risk tolerance and how much you’re willing to risk on the trade.
Likewise, choosing an appropriate expiration date depends on how much capital you must allocate to the trade and your tolerance to risk. Longer investments like these tend to cost more, and the money can be tied up for a year or more, so choosing a longer or short expiration cycle can become critical for investors who want to manage their capital correctly and not get over-leveraged in their investments.
Is Trading LEAPS Options Worth It?
In addition to traditional options trading, LEAPS is a great way to hedge investments with long positions. At the same time, index LEAPS can be used as large-scale protective puts for your entire portfolio. If used wisely, LEAPS can be a powerful tool for long-term investors.
Using a LEAPS options contract can work for your overall trading plans and objectives if:
- You want to gain exposure to stocks using a cost-efficient method
- You’d like to enjoy the higher returns that potentially come with investing in these long-term positions
- You have the capital to invest in these contracts where a profit might not be realized for a year or more
Begin exploring LEAPS as part of your long-term investing strategy and remind them to do further research or consult a financial advisor. We encourage you to check out related articles on trading strategies for other options.
Frequently Asked Questions
If you want answers to the most common questions about LEAPS options from our customers and readers, check out our list of frequently asked questions, which delivers some of the critical highlights discussed in this guide on LEAPS options contracts.
What Is the Difference between LEAPS and Regular Options?
LEAPS options will expire in one to three years, whereas standard options have expiration dates of a year or less. LEAPS options are more expensive to invest in, and their prices are less affected by the underlying price changes. Another critical difference between LEAPS and regular options is liquidity. LEAPS tend to have lower liquidity and more excellent bid-ask spreads than standard options contracts.
Can I Lose More Money with LEAPS than I Invested?
If a LEAPS contract expires as worthless, the trader or investor can lose up to their entire investment. There’s also a scenario where the underlying security can move against the trader, and they could be at risk of unlimited losses due to this exposure.
How Do I Decide Which LEAPS to Buy?
If you believe the stock will rise over the long term, purchasing a call LEAPS option is best because you have a bullish view of the market. You should choose a strike price higher than the current stock price. If you believe the stock will fall over the long term, purchasing a put LEAPS option is best because you have a more bearish view of the market. You should choose a lower strike price than the current stock price.
Are LEAPS Suitable for Beginners in Options Trading?
It depends on how much capital a new trader has to work with because it’s more expensive to enter these trades than short-term options contracts. New traders with limited or insufficient capital to dedicate to an agreement that covers one to three years may consider another trading option. LEAPS works best for those with a lot of money that can be tied up in these long-term investments.
What Are the Tax Implications of Trading LEAPS?
Traders who sell a LEAPS contract and make a profit are taxed at the long-term capital gain rate if the position is held for over a year. Positions held for a shorter time are taxed at short-term capital gain rates.
