When considering any options strategy, you may want to think about Long-Term Equity AnticiPation Securities (LEAPS) if you are prepared to carry the position for a longer term. While using LEAPS does not ensure success, having a longer amount of time for your position to work is an attractive feature for many investors. In addition, there are several other factors that make LEAPS useful in many situations.
LEAPS offer investors an alternative to stock ownership. LEAPS calls enable investors to benefit from stock price rises while placing less capital at risk than is required to purchase stock. Should a stock price rise to a level above the exercise price of the LEAPS, the buyer may exercise the option and purchase shares at a price below the current market price. The same investor may sell the LEAPS calls in the open market for a profit.
Investors also use LEAPS calls to diversify their portfolios. Historically, the stock market has provided investors significant and positive returns over the long term. Few investors purchase shares in each company they follow. A buyer of a LEAPS call has the right to purchase shares of stock at a specified date and price up to three years in the future. Thus, an investor who makes decisions for the long term can benefit from buying LEAPS calls.
Hedge
LEAPS puts provide investors with a means to hedge current stock holdings. Investors should consider purchasing LEAPS puts if they are concerned with potential price drops on stock that they own. A purchase of a LEAPS put gives the buyer the right to sell the underlying stock at the strike price up to the option's expiration.
What's the Downside?
If you are a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price you paid for the position. If you are an uncovered seller of LEAPS calls, there is unlimited risk, or a seller of LEAPS puts, significant risk. Risk varies depending upon the strategy followed, and it is important for an investor to understand fully the risk of each strategy.
Stock vs. LEAPS
There are many differences between an investment in common stock and an investment in options. Unlike common stock, an option has a limited life. Common stock can be held indefinitely, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument. As a result, even if an option investor correctly picks the direction the underlying stock will move, unless the investor also correctly selects the time frame that movement will take place, the investor will not profit as desired.
Options investors run the risk of losing their entire investment in a relatively short period of time and with relatively small movements of the underlying stock. Unlike a purchase of common stock for cash, the purchase of an option involves "leverage," whereby the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.
LEAPS are simply long-term options that expire at dates up to 2 years and 8 months in the future, as opposed to shorter-dated options that expire within one year.
LEAPS grant the buyer the right to buy, in the case of a call, or sell, in the case of a put, shares of a stock at a predetermined price on or before a given date. Equity LEAPS are American-style options, and therefore may be exercised and settled in stock prior to the expiration date. The expiration date for Equity LEAPS is the Saturday following the third Friday of the expiration month.
LEAPS are quoted and traded just like any other exchange listed option. In fact, many of the features of LEAPS are the same for shorter-term options:
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Number of shares covered by the contract (100)
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Exercise and assignment procedures
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Trading procedures
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Margin and commission costs
However, LEAPS® differ from shorter-term options in several ways including availability, pricing, time erosion vs. delta effect, symbols and strategies.
Several factors impact the availability of LEAPS. When options are listed for trading on a particular stock, most times LEAPS are not immediately available. After a period of time, and if interest warrants it, the exchanges listing the shorter-term options may decide to list LEAPS options, after consulting with the market-makers or specialists assigned to trade the stock options. The reason for this is that LEAPS options are difficult to price because of their long life. The exchanges ensure that sufficient interest is present in the market, and that market-makers or specialists are prepared to price and trade longer-dated options once they are listed. The result is that LEAPS are not available on every stock which has options traded on it. LEAPS are initially listed with three strike prices, at the current price and 20 to 25% above and below the price of the underlying stock. Strikes may be added as the underlying stock moves. LEAPS only have one expiration month: January in two different years.
As LEAPS draw within one year of their expiration and it becomes necessary to list new LEAPS series, the existing LEAPS options continue to be listed and traded until their expiration. However, because of the shorter length of time until expiration, they then trade as ordinary shorter-term options and they lose their distinctive LEAPS symbols. New LEAPS options with expiration dates in the future are then added.
