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LEAPs

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Jul 14, 2024

LEAPs, which stands for Long-Term Equity Anticipation Securities, are a type of options contract with an expiration date that is typically more than one year in the future.

These long-term options provide traders with extended exposure to potential price movements of the underlying asset, usually stocks or exchange-traded funds (ETFs) – but can be applicable to anything.

 

Key Characteristics of LEAPs

  • Expiration dates are typically 1-3 years in the future
  • Available for both call and put options
  • Often have lower time decay (theta) compared to shorter-term options
  • All else equal, more expensive than short-term options due to their longer duration

 

Advantages of Trading LEAPs

Extended Time Horizon

LEAPs offer traders the opportunity to take long-term positions without the need for frequent contract rollovers.

This extended timeframe allows for more gradual price movements and potential trend capture.

Leverage with Reduced Risk

Compared to buying the underlying stock outright, LEAPs can provide leverage with a smaller capital outlay.

They offer a way to control more shares with less upfront investment.

Lower Theta Decay

The rate of time decay (theta) is typically slower for LEAPs compared to shorter-term options.

This characteristic can be advantageous for traders looking to hold positions for extended periods.

Flexibility in Strategy Implementation

LEAPs can be used in various options strategies, including:

  • Long-term directional bets
  • LEAPS spreads (i.e., combine with other options)
  • Synthetic stock positions
  • Covered call writing

 

Disadvantages and Risks of LEAPs

Higher Premium Costs

Due to their longer duration, LEAPs generally have higher premiums than short-term options.

This increased cost can impact potential returns and require a larger initial investment.

Reduced Gamma

LEAPs typically have lower gamma, meaning they are less sensitive to small price movements in the underlying asset.

This characteristic can result in slower profit accumulation compared to shorter-term options.

Liquidity Concerns

LEAPs often have lower trading volume and wider bid-ask spreads compared to short-term options.

This reduced liquidity can make it more challenging to enter or exit positions at desired prices.

Opportunity Cost

Tying up capital in long-term options positions may result in missed opportunities for other trades.

 

LEAPS Trading Strategies

Long LEAPS Calls

Traders bullish on a stock’s long-term prospects can buy LEAPS call options to gain leveraged exposure to potential price appreciation.

This strategy allows for significant upside potential with a defined risk limited to the premium paid.

Long LEAPS Puts

For bearish outlooks or portfolio hedging, investors can purchase LEAPS put options.

These long-term puts provide protection against downside risk or allow for profiting from potential price declines.

LEAPS Spreads

Spread strategies involving LEAPs can help reduce the cost of entry and define risk-reward parameters.

Common LEAPS spread strategies include:

Bull Call Spread

  • Buy a lower strike LEAPS call
  • Sell a higher strike LEAPS call with the same expiration

This strategy reduces the cost basis and caps potential profits but also limits risk.

Bear Put Spread

  • Buy a higher strike LEAPS put
  • Sell a lower strike LEAPS put with the same expiration

This bearish strategy offers downside protection or profit potential with reduced cost and defined risk.

Poor Man’s Covered Call

This strategy involves:

  • Buying a deep in-the-money LEAPS call option
  • Selling shorter-term out-of-the-money call options against the LEAPS position

This approach simulates a traditional covered call strategy but requires less capital than owning the underlying stock outright.

 

Factors to Consider When Trading LEAPs

Implied Volatility

LEAPs are sensitive to changes in implied volatility.

Higher implied volatility typically results in higher option premiums, while lower volatility can lead to cheaper options prices.

Dividends

For stocks that pay dividends, the impact on LEAPs pricing should be considered.

Dividends can affect the fair value of options, particularly for deep in-the-money contracts.

Those holding the option won’t receive the dividend.

If ITM, they have the option to exercise the option to capture the dividend (or simply hold onto the position).

Corporate Actions

Long-term options holders should be aware of potential corporate actions, such as stock splits, mergers, or acquisitions, which can impact the value and terms of LEAPs contracts.

Tax Implications

The tax treatment of LEAPs might differ from that of short-term options or stock ownership.

Bid-Ask Spread

Options typically have higher bid-ask spreads than the underlying asset.

Sometimes the spread can represent a huge transaction cost.

 

LEAPs vs. Stock Ownership

Capital Efficiency

LEAPs offer a way to control a larger number of shares with less upfront capital compared to outright stock ownership.

This leverage can amplify gains, but the premium can be expensive.

For example, if you buy a LEAP with a one-year maturity at-the-money, you might pay 7-8% of the value of the underlying position.

This can be expensive over the long-run, though it will protect against downside risk.

Risk Profile

While LEAPs have a defined maximum loss (the premium paid), they also carry the risk of expiring worthless.

Stocks, on the other hand, have the loss potential but are a perpetual position.

Dividends and Voting Rights

Unlike stockholders, LEAPS options holders don’t receive dividends or have voting rights in the company.

 

Conclusion

LEAPs provide traders a way to implement long-term options strategies.

Their extended time horizon offers advantages in terms of reduced theta decay and the potential to capture long-term trends.

However, they also come with higher premium costs and liquidity concerns.

Successful LEAPS trading requires a thorough understanding of options mechanics, careful analysis of the underlying asset’s prospects, and consideration of various factors such as implied volatility and corporate actions.

When used appropriately, LEAPs can offer leverage, flexibility, and long-term exposure to market opportunities.