What Is a LEAP Call Option and How Does It Work?

An option contract is a financial derivative, its value derived from an underlying asset like a stock or ETF. These contracts give the holder the right, but not the obligation, to buy or sell the underlying asset at a predetermined price by a specific date. Options serve various purposes, such as hedging or speculating on future price movements. LEAP call options are a specialized category, distinguished by their extended time horizons.

LEAP call options, or Long-term Equity AnticiPation Securities, are long-term option contracts. They allow investors to express a long-term view on an asset’s price direction without outright ownership of the shares.

Understanding Call Options

A call option grants its holder the right to purchase an underlying asset at a specified price, known as the strike price, on or before a particular expiration date. This right comes at a cost, referred to as the premium. Each standard equity option contract typically represents 100 shares of the underlying asset.

The underlying asset is the security upon which the option contract is based, such as a stock or an ETF. The strike price is the fixed price at which the underlying asset can be bought if the option is exercised. For example, a call option with a strike price of $50 allows the holder to buy the underlying asset for $50 per share, regardless of its market price, until the expiration date.

The expiration date is the final day the option contract is valid. Options are categorized by their relationship to the strike price and the underlying asset’s current market price. An option is “in-the-money” (ITM) if exercising it would result in an immediate profit; for a call option, this means the underlying asset’s price is above the strike price.

Conversely, an option is “out-of-the-money” (OTM) if exercising it would not be profitable; for a call option, this occurs when the underlying asset’s price is below the strike price. An option is “at-the-money” (ATM) when the underlying asset’s price is approximately equal to the strike price.

The LEAP Distinction

LEAP call options differentiate themselves from standard call options through their significantly longer expiration periods. While conventional options typically expire within weeks or months, LEAPs have expiration dates extending beyond one year, often up to two or three years from their issuance.

This longer duration allows investors to capitalize on anticipated long-term trends without constantly rolling over shorter-term contracts. This extended timeframe provides investors with a longer window for the underlying asset’s price to move favorably. LEAPs also experience slower initial time decay compared to short-term options, making them suitable for patient investors.

Functionally, LEAP options operate similarly to shorter-dated counterparts in terms of components like the underlying security, strike price, and 100-share contract multiplier. Their distinguishing feature is the extended time to expiration, which provides more flexibility for an investment thesis to play out.

Key Factors Influencing LEAP Call Option Value

The premium of a LEAP call option is influenced by intrinsic and extrinsic value. Intrinsic value is the portion of an option’s price representing its immediate profit if exercised. For a call option, this exists when the underlying asset’s price is higher than the strike price. For example, if a stock trades at $60 and a call option has a strike price of $50, there is $10 of intrinsic value.

Extrinsic value, also known as time value, is the amount of the premium exceeding the intrinsic value. This component reflects the potential for the option to become more profitable before expiration. It is influenced by factors like time remaining until expiration and implied volatility. This extrinsic value erodes as time passes.

Time decay, quantified by Theta (θ), measures the rate at which an option’s value decreases as its expiration date approaches, assuming all other factors remain constant. For LEAPs, time decay is less pronounced in early stages compared to short-term options, but it accelerates significantly as expiration nears. This slower initial decay benefits their long duration.

Implied volatility, represented by Vega (V), indicates an option’s sensitivity to changes in the market’s expectation of future price swings in the underlying asset. Higher implied volatility leads to a higher option premium due to a greater perceived chance of significant price movement. LEAPs, with their longer duration, have higher Vega, making them more sensitive to long-term volatility expectations.

The underlying asset’s price sensitivity is measured by Delta (Δ), which estimates how much an option’s price changes for every $1 movement in the underlying asset’s price. For call options, Delta ranges from 0 to 1; a Delta of 0.70 means the option’s price increases by $0.70 for every $1 increase in the underlying asset. Deep in-the-money LEAP calls have a Delta closer to 1, indicating their price moves almost dollar-for-dollar with the underlying asset.

Interest rates, measured by Rho (ρ), also play a role, though typically smaller compared to other factors like volatility and time. Rho indicates how an option’s price reacts to a 1% change in the risk-free interest rate. For long calls, Rho is positive, meaning increasing interest rates can slightly increase their value. LEAPs, having longer durations, are generally more sensitive to interest rate changes than short-term options.

Exercising and Closing LEAP Call Options

Holders of LEAP call options have ways to manage their positions. One method is exercising the option, which involves buying the underlying asset at the predetermined strike price. This converts the option contract into actual shares. To exercise, the holder notifies their brokerage, which facilitates the purchase of shares at the strike price. This process requires sufficient capital to cover the cost of buying the shares.

Most option holders, including those with LEAPs, choose not to exercise their options. Instead, they sell their options on the open market before the expiration date. This “selling to close” allows the holder to realize profits or losses without purchasing the underlying shares. For instance, if a LEAP call option has increased in value, selling it allows the holder to capture that gain.

Selling to close is preferred because it avoids potential additional commissions associated with buying and selling the underlying shares. Selling the option also allows the holder to retain any remaining extrinsic value in the option’s premium, which would be lost upon exercise. The majority of option positions are closed out through this selling process rather than through exercise.