Content of the material
- What Are Long-Term Equity Anticipation Securities (LEAPS)?
- Key Takeaways
- The Outcome Using LEAPS
- What’s the Downside?
- Active LEAPS strategies
- Calls or Puts?
- The caveat
- How are LEAP options taxed?
- Long-Term Equity Anticipation Securities (LEAPS) vs. Shorter-Term Contracts
- Real-Life Example Using a LEAP Option
What Are Long-Term Equity Anticipation Securities (LEAPS)?
The term long-term equity anticipation securities (LEAPS) refers to publicly traded options contracts with expiration dates that are longer than one year, and typically up to three years from issue. They are functionally identical to most other listed options, except with longer times until expiration. A LEAPS contract grants a buyer the right, but not the obligation, to purchase or sell (depending on if the option is a call or a put, respectively) the underlying asset at the predetermined price on or before its expiration date.
Key Takeaways Long-term equity anticipation securities are listed options contracts that expire in more than a year.These contracts are ideal for options traders looking to trade a prolonged trend.LEAPS can be listed on a particular stock or an index as a whole.They are often used in hedging strategies and can be particularly effective for protecting retirement portfolios.The premiums for LEAPS are higher than those for standard options in the same stock.
The Outcome Using LEAPS
Your net profit on the transaction would be $6 per share on an investment of only $1.50 per share. You turned a 72.4% rise in stock price into a 400% gain by using LEAPS instead. Your risk was certainly increased, but you were compensated for it, given the potential for outsized returns.
Your gain would work out to $60,000 ($6 capital gain per share on 10,000 shares) for an initial investment of just $15,000, compared to the $10,500 you would have earned if you had bought 1,000 shares of the stock outright at a share price of $14.50, and it increased to $25 per share over time.
Buying it on margin would have helped you earn $21,000, but you would have avoided the potential for wipe-out risk, because anything above your purchase price of $14.50 would have been a gain. You would have received cash dividends during your holding period, but you would have been forced to pay interest on the margin you would have borrowed from your broker.
It's also possible that you could have been subject to the margin call if the market had tanked.
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.
Active LEAPS strategies
Active traders can benefit from LEAPS as well. LEAPS might be used by traders who would like to take a longer-term position in some of the same shorter-term options they currently trade.
For example, assume that you believe XYZ company will report disappointing earnings in the upcoming quarter, so you decide to purchase a put option. A few days later, news emerges that makes you very positive on the long-term prospects of the company. You still expect there to be some short-term problems in the earnings report, so you don’t want to close out the put option position. One strategy could be to purchase a 3-year LEAPS call to benefit from your expectation that the company will do well over the longer-term period. This allows you to maintain your short-term bearish trade and enter into a bullish long-term position.
LEAPS can also be used in advanced options strategies as well, such as a bull call spread, calendar spreads, and collars.
Calls or Puts?
If your outlook for the underlying stock is bullish over the long haul, buy call options.
On the other hand, if you think the price could drop precipitously over the next year or so, buy put options.
The good news is you aren’t limited with LEAPs. You can buy either call options or put options.
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.
How are LEAP options taxed?
Just like holding stocks outright, LEAPS are eligible for the more favorable long-term capital gains tax rate. Most of those who hold onto a LEAP option for more than one year before selling are taxed at either 0% or 15% (though high-income individuals may be taxed up to 20%). The gains from LEAPS sold exactly one year after buying (or sooner) are taxed at your normal income bracket rate.
Long-Term Equity Anticipation Securities (LEAPS) vs. Shorter-Term Contracts
LEAPS also allow investors to gain access to the long-term options market without needing to use a combination of shorter-term option contracts. Short-term options have a maximum expiration date of one year. Without LEAPS, investors who wanted a two-year option would have to buy a one-year option, let it expire, and simultaneously purchase a new one-year options contract.
This process, which is called rolling contracts over, would expose the investor to market changes in the prices of the underlying asset as well as additional option premiums. LEAPS provide the longer-term trader with exposure to a prolonged trend in a particular security with one trade.
Real-Life Example Using a LEAP Option
Let’s say Apple is trading at $175 per share. You think it’s going up significantly over the long term, so you decide to buy a LEAP option.
The $170 call option for a year out is currently trading for $24.00. You believe that Apple is going up at least $30 per share before the contract expires, so you think it’s got potential.
You check out the Greeks. That contract has a delta of 0.63. That means for every dollar that Apple stock increases in value, the option will increase 63 cents. That’s acceptable because you also know that delta will increase as the stock price increases.
The theta is -0.04. That means the option will lose 4 cents in value every day, all other things being equal. That’s also acceptable.
You buy the call option for $24. That means you spend $2,400 because options are sold in blocks of 100 shares ($24 x 100 = $2,400).
Sure enough, after several months, Apple reports record earnings and the stock price shoots up to $198 per share. The option you bought is now worth $41. You sell the position for $4,100 ($41 x 100).
That means your return is a whopping 70%!
Now compare that to what you’d get if you bought 100 shares of stock. You’d pay $17,500 ($175 x 100) for the position and sell the stock for $19,800 ($198 x 100). That would give you a return of just 13%.
So if you bought the stock you’d invest a lot more money for a much smaller return.
That’s what makes LEAP options attractive to so many traders.