Long-term equity anticipation securities (LEAPS) are option contracts that are publicly traded with expiration dates that are longer than one year. LEAPS grant a buyer the advantage to purchase or sell (depending on if the option is a call or a put) an underlying asset at the predetermined price on or before its expiry date. LEAPS tend to be more affordable than stocks because they are offered at option contract prices. LEAPS serves as long-term investments, giving an investor enough time to take advantage of stock price movements, the high cost of the underlying securities notwithstanding.
With LEAPS, investors pay a premium, that is, an upfront fee to be able to buy or sell above or below the option's strike price. The strike is the price that is decided upon for the asset in question at which it converts at expiry. For instance, a $55 strike price for an Apple (ticker: AAPL) call option would mean an investor could buy 100 shares of AAPL at $55 upon expiry. The investor will be able to exercise the $55 option if the market price is higher than the strike price. However, if the price is less, the investor will allow the option to expire and then lose the money paid for the premium.
LEAPS contract, otherwise known as premiums, refer to a nonrefundable amount of money needed to trade in the options market. The premiums for LEAPS are higher than those for standard options in the same stock market.
The spread-out expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. The time value of a LEAP premium makes use of the long timeframe and intrinsic value of the contract to determine the value of the option. The intrinsic value is the estimated value of how an option would be profitable and arrived at by considering the difference between the asset's market price and strike price.
Assuming a premium for Apple option is $8, an option buyer is expected to pay the sum $800, which is $8 x 100 = $800.
The volatility of the stock, the market interest rate, and if the asset returns dividends are all factors that can affect the price of a LEAPS premium. Throughout the life span of the contract, an option will have a theoretical value derived from the use of various pricing models. This fluctuating price indicates what the holder may receive if they sell their contract to another investor before expiration.
Types of LEAPS Contract
There are two types of LEAPS contract. They include LEAPS calls and LEAPS put.
LEAPS call options give investors the opportunity to benefit from potential rises in a specific stock while using less capital than purchasing shares with cash up-front. In this case, the cost of the premium is lower than the cash needed to buy 100 shares. LEAPS calls allow investors to exercise their options by purchasing the shares of the underlying stock at the strike price. LEAPS calls are beneficial because they allow the holder to sell the contract at any time before the expiry date. The difference in premiums between the purchase and sale prices can lead to a profit or loss. Investors must also include any fees or commissions charged by their broker to buy or sell the contract.
This type of LEAPS contract provides investors with a long-term hedge if they own the underlying stock. As underlying stock prices decline, put options increase in value and potentially offsetting the losses incurred for owning shares of the stock.
For instance, an investor who owns shares of ABC Corp. and wishes to hold them for the long term might be scared of the stock price falling. The investor can proceed to buy LEAPS putting on ABC to hedge against unfavorable moves in the long stock position, helping the investor to benefit from price declines without the need to short sell shares of the underlying stock. In the process of short selling, shares are borrowed from a broker and sold with the expectation that the stock will continue to depreciate by expiry. At expiry, the shares are purchased, at a lower price (under probability) and the position is netted out for a gain or loss. Shorting could be very risky if the stock prices are rising instead of falling, leading to significant losses.
We would be explaining LEAPS using the example below:
Assuming an investor holds a portfolio of securities, comprising the S&P 500 constituents, and the investor thinks a market correction will take place within the next two years, he would purchase index LEAPS puts on the S&P 500 Index to hedge against adverse moves. He may buy a December 2022 LEAPS put option with a strike price 6,000 for the S&P 500 and pays $600 upfront for the right to sell the index shares at 6,000 on the expiration date of the option. If the index falls below 6,000 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 rises, the LEAPS put option will expire worthlessly, and the investor would be out the $600 premium.
Just like how a market index represents 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. Index LEAPS allows investors to hedge and invest in indices such as the Standard &Poor's 500 Index (S&P 500).
Index LEAPS gives the bearer the opportunity to track the entire stock market or specific industry sectors as well as allowing investors to take a bullish stance using call options or a bearish stance using put options, and finally, hedge their portfolios against adverse market moves with index LEAPS puts.
Advantages of LEAPS
The long timeframe associated with LEAPS allows the selling of the option.
LEAPS are available for equity indices.
LEAPS can be used to hedge a long-term holding or portfolio.
Disadvantages of LEAPS
The premiums paid in LEAPS are quite expensive
Market movement may be adverse or share may become volatile
The long time frame ties up the investment funds