What Are LEAPS Options and How Do They Work?
Understand LEAPS options: long-term contracts providing extended exposure to assets with distinct advantages over standard options.
Options contracts grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a certain date. Long-term Equity AnticiPation Securities, commonly known as LEAPS, have significantly longer expiration periods. These financial instruments offer investors a different approach to market participation compared to shorter-term options. This article explains what LEAPS are, how they function, and important considerations for investors.
What are LEAPS Options
LEAPS, or Long-term Equity AnticiPation Securities, are options contracts with extended expiration dates, typically from just over one year to three years. They function similarly to regular options, providing the holder the right to buy (call option) or sell (put option) an underlying asset at a specified price. These contracts are available for individual stocks, exchange-traded funds (ETFs), and market indices.
When an investor purchases a LEAPS contract, they pay a premium, the cost of acquiring the option. This premium grants control over 100 shares per contract at a predefined strike price. For example, a LEAPS call option on a stock with a $60 strike price expiring in two years gives the buyer the right to purchase 100 shares at $60 per share until expiration. A LEAPS put option with a $45 strike price expiring in two years gives the buyer the right to sell 100 shares at $45 per share.
Key Differences from Standard Options
The primary distinction between LEAPS and standard options is their expiration period. Standard options typically expire within weeks to less than a year, while LEAPS extend beyond one year and often up to three years. This extended timeframe significantly impacts how time decay, or theta, affects the option’s value. Time decay is the gradual erosion of an option’s extrinsic value as its expiration date approaches.
LEAPS experience a slower rate of time decay in their earlier life compared to short-term options. This is because a longer period allows the underlying asset’s price to move favorably, making the time value component of the premium erode more gradually. However, as a LEAPS contract approaches its final year or months, the rate of time decay accelerates. Due to this extended time horizon, LEAPS generally carry higher premiums than comparable short-term options. The longer duration also provides more flexibility in strike price selection, as there is a greater window for the underlying asset to reach or surpass a given strike price.
How LEAPS Function
LEAPS allow investors to express a long-term directional view on an underlying asset. They enable a position that benefits from a sustained upward trend (with a call option) or a downward trend (with a put option) without requiring precise short-term market timing. This long-term outlook reduces the pressure associated with rapid price movements common in shorter-term options.
LEAPS also offer leverage and capital efficiency. By purchasing a LEAPS contract, an investor can control 100 shares per contract for a fraction of the capital required to buy the shares outright. For instance, instead of spending thousands to acquire 100 shares of a high-priced stock, an investor might spend a few hundred or a thousand dollars on a LEAPS call option, achieving similar directional exposure. This allows investors to allocate less capital, potentially freeing up funds for other investments, enhancing capital efficiency.
LEAPS can serve as an alternative to directly owning or shorting shares for long-term exposure, providing a defined maximum loss limited to the premium paid. This is a benefit compared to the potentially unlimited risk of shorting stock or the full capital at risk when buying stock.
Important Considerations
When considering LEAPS, implied volatility is a significant factor. It reflects the market’s expectation of future price movements for the underlying asset and directly impacts the option’s premium. Higher implied volatility generally leads to higher LEAPS premiums, even if the underlying asset’s price remains stable. Changes in implied volatility can significantly affect the value of LEAPS contracts, so consider volatility levels when entering a position.
Thorough research of the underlying asset is also paramount, given their long-term nature. Since these options are held for an extended period, fundamental analysis of the company or long-term trends of the ETF or index is more critical than short-term technical indicators. Investors should assess the underlying’s financial health, industry outlook, and growth prospects.
Liquidity is another practical consideration. Popular stocks and indices tend to have liquid LEAPS contracts, but less common underlying assets may have wider bid-ask spreads and lower trading volumes. Low liquidity can make it challenging to enter or exit positions at desired prices without incurring higher transaction costs. LEAPS positions do not need to be held until expiration; investors can sell their contracts in the open market at any time to realize gains or limit losses.