LEAPs
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.