Investment Tips 29-04-2023 22:22 40 Views

LEAP Options Explained: What Are They And How Do They Work?

Description of LEAP Options

A LEAP option is essentially an option with longer terms than standard options. The acronym "LEAP" stands for Long Term Equity Anticipation Security and like standard options, LEAPS come in two forms: calls and puts.

 

These long-dated options are available on approximately 2500 securities and several indexes. Standard options are typically available in monthly cycles, and many are now also available in weekly cycles.

 

LEAPS, on the other hand, may extend out for a couple years and always expire in the month of January.

 

An investor may use LEAPS if they are bullish or bearish a stock or index, but think that there opinion may take some time to play out. For example, suppose that investor Bob is bullish on stock ABC which is currently trading at $40 per share.

 

Bob thinks the company has great fundamentals, and it is currently in the process of bringing several new products to market. Bob thinks the stock price could potentially go to $80 per share or even higher if the company is successful with the launch of its new products. Bob's understanding is that the products may take anywhere from 9-15 months to bring to market.

 

Bob could simply buy shares of ABC at $40 per share now and hope that the stock price does climb in the months ahead. That, however, could tie up a great deal of Bob's investment capital for a significant period of time. Bob makes the decision to purchase a LEAP call option that expires in one year with a strike price of $55 per share for a premium of $5.00

 

Bob's risk is now limited to the $5 premium he paid for the call option. His potential upside is technically unlimited. If the stock price is below the option strike price of $55 at expiration, Bob will lose the entire $5 premium paid.

 

If the stock rockets higher, however, Bob could potentially profit point-for-point once the share price rises above the break-even level of $60 per share. If the share price were to climb to $85, for example, Bob could potentially see a profit of $25 per share.

 

At that point, Bob could simply sell the option back to the market or he could exercise is options to obtain a long position in the stock at $55.

 

When To Put It On

LEAP options may be used to make long-term bets on a stock or index going up or down.

 

A call option can be put on when one is bullish the stock, but thinks their bullish thesis will take some time to develop. A put option can be put on if one is bearish on a stock, but again thinks that their bearish thesis may take some time to unfold.

 

In this way a high positive delta LEAP call is often used as a low capital required stock replacement strategy.

LEAPs may also be used to hedge a long or short position in a stock or index. If an investor owns shares in company YYY, which pays a handsome dividend, then he or she may look to purchase long-term puts to hedge their downside risk.

 

Pros of LEAP options

LEAPS may have numerous potential benefits. If LEAPS are purchased, then the maximum risk of the position is limited to the premium paid. LEAPs may also potentially allow for a better use of capital and higher ROI.

  • 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.
     
  • 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.

 

Cons of LEAP options

LEAPs also have some negatives as well. if one is buying LEAP options, those options will lose value over time as the effects of theta, or time decay, take a toll with all other inputs remaining constant. Options can also be affected by changes in implied volatility, potentially fueling gains or losses. Due to the amount of time premium that may be built into LEAPs, they may also be cost prohibitive.

The prices for LEAPS are highly sensitive and subject to market volatility and interest rate fluctuations.

 

Risk Management

LEAP options can be managed just like standard options with some caveats. An investor could simply decide, for example, to cut their losses once the value of an option declines by a specified amount. Investors may also potentially choose to cut a position once the option reaches a certain amount of time until expiration.

 

LEAPs may be less liquid than standard monthly or weekly options, however, so risk management could potentially become more challenging. For investors that sell LEAP options, the risk is unlimited on the upside and only limited by zero on the downside (since a stock can go to zero).

 

Only investors with a solid understanding of options and the risks involved with selling options should attempt LEAP selling strategies. Even then, losses may not be avoided and investors must be willing to assume the unlimited risks involved.

 

Investors may, however, limit the risk of selling a LEAP option by purchasing another option further out-of-the-money, creating a limited-risk credit spread.'

 

Possible Adjustments

LEAP positions may be adjusted using various methods like standard options if liquidity is not an issue.

 

Strike prices may be adjusted as well as expiration dates. For example, if a LEAP is approaching its expiration date but the investor still believes a big run higher may be seen in the months ahead, he or she could sell their LEAP call option back to the market and purchase a new LEAP call option that expires the following year.

 

Used under the appropriate circumstances, LEAP options can be a useful tool for betting on market direction as well as hedging exposure in the underlying stock or index.

About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.

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