What Are Long-Term Equity Anticipation Securities (LEAPS)?

What Are Long-Term Equity Anticipation Securities (LEAPS)?

Let me explain what Long-Term Equity Anticipation Securities, or LEAPS, really are. These are options contracts with expiration dates that go beyond one year, sometimes up to three years. They let you, as an investor, get exposure to long-term price changes in the underlying asset, just like regular options but with a longer timeframe. If you buy a LEAPS contract, you get the right—but not the obligation—to buy or sell the asset at a set price, depending on if it's a call or a put.

Key Takeaways on LEAPS

You need to know that LEAPS expire after more than a year, giving you a shot at profiting from long-term market shifts. You can use them to hedge against market drops or speculate on price rises, which adds flexibility to your strategy. But remember, they have higher premiums than short-term options, and there's risk—you could lose the entire premium if the option expires worthless. Index LEAPS let you hedge whole portfolios against moves in indices like the S&P 500, offering broad protection. Introduced by the Cboe in 1990, LEAPS are now common in options trading, but watch out for their costs and the chance of big losses if the market turns against you.

Deep Dive into LEAPS: Structure and Benefits

LEAPS aren't much different from short-term options except for their longer expiration dates. This extended maturity means you can capitalize on price movements over a longer period. Just like with short-term options, you pay a premium to buy or sell at the strike price, which is the fixed price for executing the contract at expiration.

Take this example: if there's a $25 strike price for a GE call option, you could buy 100 shares of GE at $25 when it expires. You'd exercise it if the market price is above $25; if not, you'd let it expire and lose the premium. Each option covers 100 shares. You have to realize that your funds are committed in these long-term contracts. Changes in market interest rates and asset volatility can impact the option's value, based on how they move.

Leveraging Index LEAPS for Strategic Market Exposure

A market index is basically a hypothetical portfolio of assets representing a market segment or industry. There are LEAPS for equity indexes, too. Like stock LEAPS, these let you hedge or invest in indices such as the S&P 500. With index LEAPS, you can track the overall market or specific sectors, going bullish with calls or bearish with puts. You could also use puts to hedge your portfolio against bad market moves.

Decoding LEAPS Premiums: Costs, Value, and Influencing Factors

Premiums are the non-refundable price you pay for an options contract. LEAPS premiums are higher because the longer expiration gives more time for the asset to move and potentially profit. This time value, combined with intrinsic value, sets the option's total value.

Intrinsic value is the estimated profit potential based on the difference between the market price and strike price—it might include built-in profit before you even buy. The writer uses fundamental analysis to set this. Since options are based on 100 shares, if a Meta premium is $6.25, you'd pay $625 total ($6.25 times 100). Factors like stock volatility, interest rates, and dividends affect the premium. Over the contract's life, its theoretical value comes from pricing models, showing what you might get if you sell it early.

Fast Fact

LEAPS were first introduced by the Cboe in 1990, and they're now everywhere in options trading.

Comparing LEAPS and Short-Term Options: Key Differences

LEAPS give you access to long-term options without combining shorter contracts. Short-term options max out at one year. Without LEAPS, for a two-year play, you'd buy a one-year option, let it expire, and buy another— that's rolling over, and it exposes you to price changes and extra premiums. LEAPS let you capture a prolonged trend with just one trade.

Exploring the Different Types of LEAPS: Calls and Puts

Let's break down calls first. Equity LEAPS calls let you benefit from stock rises using less capital than buying shares outright—the premium is cheaper than 100 shares. Like short-term calls, you can exercise to buy at the strike price. You can also sell the contract anytime before expiration, with profit or loss based on premium differences, plus fees.

Now, puts. LEAPS puts offer a long-term hedge if you own the stock. They gain value as the stock price drops, offsetting losses. For instance, if you own XYZ shares and fear a drop, buy LEAPS puts to hedge without short selling, which is risky if prices rise instead.

Weighing the Pros and Cons of LEAPS Investment

Investing in LEAPS has benefits and drawbacks. The long timeframe means you can sell the option. You can use them to hedge against fluctuations in your long-term portfolio. Plenty of options exist for equity indices, so you can hedge against market moves and take bullish or bearish stances on the market overall. LEAPS prices aren't as sensitive to small movements in the underlying asset.

On the downside, premiums are costlier. Your money is tied up for the contract's duration, so you might miss other opportunities. You could face adverse market or company moves affecting your position. Prices are sensitive to volatility and interest rate changes.

Example of LEAPS

Suppose you hold a portfolio heavy in S&P 500 stocks. You think a correction might hit in the next two years, so you buy index LEAPS puts on the S&P 500 to hedge. You purchase a December 2021 put with a 3,000 strike, paying $300 upfront. If the index drops below 3,000 by expiration, the put gains value, offsetting portfolio losses. If it rises, the put expires worthless, and you lose the $300.

Are LEAPS a Good Investment?

LEAPS are just long-dated calls or puts on stocks or indexes. They have higher premiums and lose value over time, all else equal. Their value moves with (or against) the underlying. For some, they're a cheaper way to take a long position than buying stock.

When Should You Buy LEAPS?

If your horizon is medium-term, a LEAPS call could be a speculative bet on a rising stock. You can also buy puts for downside hedging on existing positions.

Can You Lose Money With LEAPS?

Yes, you can lose your full investment if it expires worthless. Selling LEAPS exposes you to unlimited losses if the underlying moves against you.

Do You Pay Taxes on LEAPS?

Yes, profits from selling LEAPS are taxable. Hold for over a year for long-term capital gains rate; shorter, and it's short-term.

What Is the Downside of LEAPS?

You put up more capital upfront for the premium, and since they last longer, they cost more than traditional options.

The Bottom Line

Launched by the CBOE in 1990 to meet demand, LEAPS are now standard in options trading. They stand for Long-Term Equity Anticipation Securities—listed calls and puts with expirations over a year, up to 39 months. Like all options, they have risks, so understand the potential upsides and downsides before diving in.