Content of the material
IntroductionWhen 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, several other factors make LEAPS® useful.
A market index is a theoretical portfolio made up of several underlying assets that represent a market segment, industry, or other groups of securities. There are LEAPS available for equity indexes. Similar to the single equity LEAPS, index LEAPS allow investors to hedge and invest in indices such as the Standard & Poor’s 500 Index (S&P 500).
Index LEAPS give the holder the ability to track the entire stock market or specific industry sectors and take a bullish stance using call options or a bearish stance using put options. Investors could also hedge their portfolios against adverse market moves with index LEAPS puts.
How LEAPS Could Work
This scenario could play out in any of a few different ways.
- You'll suffer some loss of capital if the stock trades between $17.51 and $19 per share when the option expires in two years, and you'll have a 100% loss of capital if it trades below your $17.50 call strike price.
- You could call your broker and close out your position if the stock does rise substantially.
- You could force someone to sell you the stock for $17.50 per share and then immediately turn around and sell the shares you bought at the higher price per share if you elect to exercise your options. You'd pocket $6 per share—the capital gain of $7.50 minus the $1.50 you paid for the option—if it were to rise to $25.
What’s the Downside?If you are a buyer of LEAPS® calls or LEAPS® puts, the risk is limited to the price paid for the position. If you are an uncovered seller of LEAPS® callsHover to view help pop-upSelect to view help pop-upA short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential., there is unlimited risk. As a seller of LEAPS® putsHover to view help pop-upSelect to view help pop-upA short put option in which the seller (writer) does not own the cash equivalent of the exercisable value represented by his or her options contracts or an offsetting long put options contract. If assigned the seller is obligated to purchase the underlying security at the strike price. As the underlying security can go as low as zero, the writer faces substantial loss potential., there is significant risk. Risk varies depending upon the strategy followed. It is important for an investor to understand fully the risk of each strategy.
You must keep in mind that even long-term options have an expiration date. If the stock shoots skyward the day after your option expires, it does you no good. Furthermore, as expiration approaches, options lose their value at an accelerating rate. So pick your time frame carefully.
As a general rule of thumb, consider buying a call that won’t expire for at least a year or more. That makes this strategy a fine one for the longer-term investor. After all, we are treating this strategy as an investment, not pure speculation.
The Temptations and Dangers of Using LEAPS
Using LEAPS doesn't make sense for most investors. They should only be used with great caution and by those who:
- Enjoy strategic trading
- Have plenty of excess cash to spare
- Can afford to lose every penny they put into the market
- Have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy
The biggest temptation when using LEAPS is to turn an otherwise good investment opportunity into a high-risk gamble by selecting options that have unfavorable pricing or would take a near miracle to hit the strike price.
You might also be tempted to take on more time risk by choosing less-expensive, shorter-duration options that are no longer considered LEAPS. The temptation is fueled by the extraordinarily rare instances when a speculator has made an absolute mint.
Real-World Example of Long-Term Equity Anticipation Securities (LEAPS)
Let’s say an investor holds a portfolio of securities, which primarily includes the S&P 500 constituents. The investor believes there may be a market correction within the next two years and, as a result, purchases index LEAPS puts on the S&P 500 Index to hedge against adverse moves.
The investor buys a December 2021 LEAPS put option with a strike price of 3,000 for the S&P 500 and pays $300 upfront for the right to sell the index shares at 3,000 on the option's expiration date.
If the index falls below 3,000 by expiry, the stock holdings in the portfolio will likely fall, but the LEAPS put will increase in value, helping to offset the loss in the portfolio. However, if the S&P 500 rises, the LEAPS put option will expire worthless, and the investor would be out the $300 premium.