If you are looking for a way to pump up your trading returns, then LEAPS may be the answer.
Long-term equity anticipation securities (LEAPS) are publicly traded options contracts with expiration dates that are longer than one year. This is in contrast to traditional options, which usually expire within 6 months.
Put simply, LEAPS possess all the same characteristics as standard options, just with a longer life.
As a trader, it allows you to utilize a smaller degree of capital compared to buying stock outright. This creates the potential to earn bigger returns if you correctly guess the direction of the price.
However, because of the longer time until expiration, LEAPS cost more than traditional options. This is due to the greater probability that over time the options will be in the money.
Like all options, they give you the choice, but not the obligation to buy/ sell the underlying asset. You can do this on or before its expiration date, in accordance with the strike price.
LEAPS are available on thousands of equities and many indexes. And just like traditional short term options, they are available as both puts and calls.
With further out expiration dates, these options can be quite useful for both long-term investors and traders.
Pump up the Profits
Below you will see both advantages and disadvantages of LEAPS. They can be used in place of short-term options or direct stock ownership. As well as a way to hedge your position.
Hedge meaning is an investment that can reduce the risk of adverse price changes in a particular asset. A hedge usually includes taking an offsetting position in a security.
LEAPS vs. Short-Term Options
The primary difference between LEAPS and standard short-term options, such as weekly and monthly options is time. LEAPS allow for more time to be right about the direction of the stock. And because there is more time for the predicted move to play out, LEAPS behave more closely to the underlying stock.
However, the added time value also makes LEAPS more expensive than shorter-term options.
For example, here’s a look at a 1-month call vs. a leap stock.
As you can see, since the LEAP is more expensive than the short-term option… your maximum loss is greater. Not only that, your break-even point will be farther away than the short term option.
Since your maximum risk is the initial premium paid, you are risking more capital up front with the LEAPS option. So there is a balance between the value of the added time and the increased up front cost.
And while LEAPS are available on thousands of stocks, they are not, however, available for every short-term optionable stock.
LEAPS In LIEU of Stock Ownership
The longer time provided with LEAPS can provide you with another tool in managing your portfolio. Instead of just buying the stock outright. As an investor, you can use them instead of buying stock or as a hedge against stock you already own.
Buying LEAPS calls allows you to benefit from a potential increase in a stock or index over the course of a few years. Since they cost less than buying the stock and tend to move in step with the price. You can profit from your decisions without tying up all your capital in the stock.
Assume you believe a stock will go up in price over the next couple of years. Instead of purchasing the stock, you might decide to buy a 2-year LEAPS option.
- Options can enhance return. LEAPS allow you to control a greater number of shares with less money.
- The potential loss of the trade may be reduced. The maximum loss when purchasing LEAPS is the cost of the option. Whereas the max loss when buying stock is the result of the stock going to zero.
These benefits might make LEAPS an attractive choice if you can manage risk properly.
Less money, More control, Higher return
Here’s an example of how a LEAPS call option can increase your return. Theoretical example for simplicity:
- XYZ is $50/ share. 100 shares of stock = $5000
- LEAPS = $7 = option to control 100 shares is $700
- XYZ goes to $60/ share. 100 shares of stock = $6000 = +20% return
- LEAPS now = $10 = $1000 for your contract = +42% return
- XYZ now goes to $65/ share. 100 shares of stock = $6500 = +30% return
- LEAPS now = $15 = $1500 for your contract = +114% return
As you can see, the LEAPS contract returns a higher amount if you are right. Investing your full capital in LEAPS is risky at best, as you can lose the full amount if it expires worthless.
Magnify Your Return
Instead of dumping all of your capital in contracts and hoping for the best. Look at how to magnify your return without risking your whole account.
LEAPS are better suited to increase your return by putting the bulk of your money in the stock or index and using a small portion in LEAPS contracts.
- $5,000 total investment
- 72 shares of stock at $50 = $3,600 + 2 LEAPS contracts for $1,400
- At $60/ share, you can see the LEAP begins to magnify your return = 26.4% vs. a stock only return of 20%. And it takes off from there.
- At $75/ share the return jumps to 108% vs. the stock only return of 50%
With this strategy you will take on a risk of $1400 should the LEAPS expire worthless. This is due to the premium you pay up front. The risk, however, also gives you the opportunity for a much greater gain.
Use a mixture of buying the stock in conjunction with LEAPS. With this, you can limit the super risky side of LEAPS alone while also receiving the benefits of increasing your gains when you are right.
Active traders can benefit from LEAPS as well. LEAPS contracts might be used by traders who would like to take longer-term positions in some of the stocks they currently trade on a short-term basis.
LEAPS can also be used in advanced options strategies such as calendar spreads, bull call spreads, and collars.
Besides the traditional speculative options trading, LEAPS can be an effective tool for hedging. As a long term investor, you can buy LEAPS puts to hedge against a long position.
Buying puts can help you hedge against a decline in the stock or index over time. You may be long a stock that has appreciated in value, but are worried about a decline in the short term. Of course, you don’t know when it will happen, so you don’t want to sell the stock and miss any potential appreciation in the meantime. With this in mind, you can buy LEAPS puts as a hedge against a potential price decline.
With LEAPS you don’t have to be precise with the timing of the downturn because of the long time frames it offers. Short-term options, however, create a need to be more precise with your timing.
The purchased put essentially locks in some of the unrealized profit, less the cost of the option.
Suppose you purchased 500 shares of XYZ at $10 per share. Several months later the stock is trading at $30 per share.
You still want to own the stock long term. However, you are concerned about a decline in the next year or two. Consider LEAPS puts to lock in the gains.
This could be done, for instance, by purchasing 5 XYZ one year $30 strike price LEAPS at $3.6 for a total of $1800 (3.6 x 100 = 360 per contract x 5 contracts =$1800)
If the stock were to rise to $50, the put would expire worthless, resulting in a loss on the LEAPS contracts of $1,800 (the cost of the option). The total profit, however, would be $18,200 ($20,000 from the sale at $50 – the $1,800 option premium).
If the stock had gone down to $20, you would be able to sell at $30 for a profit of $8,200 ($10,000 from the sale at $30 – $1,800 premium). Whereas if you didn’t have the LEAPS contracts, you would be selling at $20 for a profit of $5,000.
The $1800 premium lets you lock in profit at the same time as allowing you to continue to profit from increases in the stock price. And protect you from a major sell off.
Risks and Dangers of Using LEAPS
- Forfeit shareholder benefits such as dividends and voting rights
- Due to the high premium paid, it takes longer for the LEAPS contracts to break even when compared to the underlying stock
- Impulse to take a high-risk gamble by buying options with very low odds of hitting the strike price
- Impulse to over leverage creating higher odds of blowing out your account
LEAPS are a type of options contract with expiration dates longer than one year. The main benefits of a LEAPS option are:
- The ability to use less capital when compared to owning the actual stock.
- You can use a longer time frame allowing you to not worry about the short-term volatility of the trade.
- Hedge risk in a trade over a longer time frame.
However, using LEAPS doesn’t make sense for most investors when looking at it as a stand-alone all-in trade. For the average investor, they are best used as hedges. As well as trading them in conjunction with owning the underlying asset to magnify your return.
When trading or investing using LEAPS, only use them with great caution if you have the training and experience. Before getting involved take time to gain the knowledge and properly assess the risks.