Are LEAPs Real? Explaining Long-Term Stock Options

Long-term Equity AnticiPation Securities, commonly known as LEAPs, are financial instruments traded on organized exchanges. These options contracts are distinguished by their extended time horizon. Investors can utilize LEAPs to express a long-term view on an underlying asset, offering a different approach compared to direct stock ownership. This article explains their core components, how they operate, and the market factors that influence their value.

Defining LEAPs

LEAPs are options contracts that possess longer expiration periods than standard options. While traditional options typically expire within a year, LEAPs commonly have expiration dates extending beyond one year, often reaching up to three years from their initial listing date. This extended timeframe is a defining characteristic, providing investors with a prolonged window for their investment thesis to unfold.

These contracts are tied to an underlying asset, which can be an individual stock, an exchange-traded fund (ETF), or an index. Each LEAP contract specifies a strike price, the predetermined price at which the underlying asset can be bought or sold. When an investor purchases a LEAP, they pay a premium, the upfront cost of acquiring the contract. The premium for LEAPs is higher than for shorter-term options due to the increased time value associated with their extended expiration dates.

LEAPs come in two forms: call options and put options. A LEAP call option grants the holder the right, but not the obligation, to purchase the underlying asset at the strike price on or before the expiration date. Conversely, a LEAP put option provides the holder with the right, but not the obligation, to sell the underlying asset at the strike price on or before the expiration date. Each standard LEAP contract represents 100 shares of the underlying security.

How LEAPs Function

Purchasing a LEAP option provides the holder with the ability to engage in a transaction involving the underlying asset at a set price. This flexibility means the holder can choose whether or not to exercise their right, depending on market conditions. LEAPs are traded on exchanges, functioning similarly to individual stocks.

Investors can exercise the contract, converting the option into shares of the underlying asset. For a call option, exercising means buying shares at the strike price. For a put option, it means selling shares at the strike price. American-style options, including equity LEAPs, allow for exercise at any time before the expiration date.

When an investor exercises a call option, the premium paid is included in the stock’s cost basis. For tax purposes, if a LEAP call option is exercised and the stock sold immediately, any profit is treated as a short-term capital gain. The holding period for determining long-term versus short-term capital gains tax rates begins on the date the stock is acquired through exercise, not the option purchase date.

Most LEAP holders do not exercise their options directly into shares. Instead, they close their positions by selling the LEAP option on the open market before its expiration. Gains or losses from selling a LEAP contract are recognized when the position is closed. If a LEAP is sold for a profit, the gain is taxable, with the holding period determining short-term (less than one year) or long-term capital gains rates. If the LEAP expires out-of-the-money, meaning it is not profitable to exercise, the contract becomes worthless, and the entire premium paid is lost.

Factors Influencing LEAP Value

The premium, or price, of a LEAP option is influenced by several variables. The price movement of the underlying asset impacts the LEAP’s value. As the price of the underlying stock or ETF increases, the value of a call LEAP rises, while the value of a put LEAP decreases. Conversely, a decline in the underlying asset’s price leads to a decrease in call LEAP value and an increase in put LEAP value.

Time decay, often referred to as Theta, describes the natural erosion of an option’s value as it approaches its expiration date. While LEAPs have an extended time horizon, offering a longer period for the underlying asset to move favorably, they are still subject to this phenomenon. The rate of time decay is slower for LEAPs in their early life compared to shorter-term options, but it accelerates as the expiration date draws near.

Implied volatility, known as Vega, measures the market’s expectation of future price swings in the underlying asset. Higher implied volatility suggests that market participants anticipate larger price movements, which leads to higher LEAP premiums for both calls and puts. This is because greater expected volatility increases the probability of the option ending up in-the-money. A decrease in implied volatility results in lower premiums.

Interest rates, represented by Rho, also play a role in influencing LEAP premiums, although their effect is less pronounced than other factors. An increase in prevailing interest rates boosts the value of call options and decreases the value of put options. This impact is more noticeable for longer-term options like LEAPs compared to short-term contracts.

Anticipated dividends from the underlying stock can also affect the pricing of LEAP options. When a company announces a dividend, the stock price drops by the dividend amount on the ex-dividend date. This expected price drop negatively impacts the value of call options, as the potential for the stock price to rise is reduced. Conversely, this same price drop can increase the value of put options, as it enhances the potential for the stock price to fall. LEAP option holders do not receive dividend payments; only shareholders of the underlying stock are eligible for dividends.