LEAPS Explained: Understanding Long-Term Equity Options

LEAPS (Long-Term Equity Anticipation Security) are options for terms that are longer than those of the most common options on equities and indices. Around 2,500 equities and 20 indices make LEAPS available in two forms: calls and putsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price..

Summary

• LEAPS are options with extended expiration periods (up to two years) on many equities and indices.
• There are two forms of LEAPS, as with traditional options: calls – which are exercised when strike prices are lower than market value, and puts – which are exercised when strike prices are higher than market value.
• More risk is attached to LEAPS. Therefore, they should be used only by the most experienced, financially stable investors.

Traditional Options

Traditional options typically come with three expiration cycles:

• Three months
• Six months
• Nine months

None of the options lasts longer than one year. It is the state of practically all options on the market today. So, what is an option? Basically, an option gives its holder the opportunity to either buy or sell an asset/security for a certain strike priceStrike PriceThe strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on either on or before the option’s specified expiration date. If the option gives the owner the right to buy at a specified price, the option is known as a call.

If the option allows the owner to sell at a specified price, the option is known as a put. Call options are usually exercised when strike prices are lower than the underlying asset’s market price. Put options, then, are exercised when the strike prices are above the current market price.

Breaking Down LEAPS

LEAPS was first introduced in 1990. They were sold exclusively as derivative instruments for stock trading that could extend the options on securities and assets for up to two years.

Option owners can use the secondary market to sell their options to a third party. It can be done either over-the-counter (OTC)Over-the-Counter (OTC)Over-the-counter (OTC) is the trading of securities between two counter-parties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks. or on an options exchange. American-style option strike prices are generally fairly close to the market price of the underlying asset. The option’s market price varies according to a variety of factors, which include:

• If a buyer is trying to compile a significant option holding, which increases demand
• An option holder (for financial reasons) needs to sell his options, which increases supply
• The time remaining before the option expires
• What analysts/investors believe the likelihood of the asset meeting or exceeding the option’s strike price before the expiration

Option holders typically don’t possess the extended rights that come with owning the underlying assets the options are attached to. The extended rights include income (dividendsDividendA dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.) and voting rights (shareholders usually get some say within a company, depending largely on how many shares they hold).

Benefits and Drawbacks of Using LEAPS

What are the benefits of using LEAPS? The extended time before expiration leaves a bigger window in which underlying security prices can move, which means a higher potential for the option to prove profitable. The “time value” – the value attached to the option due to the time left to become profitable before expiring – of LEAPS erodes more slowly than is the case with traditional options.

LEAPS are, however, more costly than their more short-term cousins with the same strike prices. The primary risk that an option buyer faces is the initial premium he pays. LEAPS buyers are putting up more capital at the beginning of the process.

LEAPS aren’t ideal for many investors. The long-term expiration period is tempting. However, they are best suited to investors who can effectively employ strategic trading and can afford to put up substantial capital, knowing they might not see a penny of it back when all is said and done.

More Resources

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