LEAPS options are long-term contracts that give the buyer the right to purchase or sell a security at a fixed price on or before a given date. LEAPS have expiration dates of at least one year.
Because of their extended time until expiration, LEAPS provide investors a cost-effective alternative to buying or selling a stock. However, they also come with unique risks, so it's important to understand how LEAPS work before investing in them.
Here are the basics of LEAPS options and how you can use them to your advantage.
What are LEAPS options?
LEAPS is an acronym for Long-Term Equity Anticipation Securities.
Like traditional options, LEAPS give the buyer the right, but no obligation, to buy or sell a security at a fixed price on or before a given date.
The key difference is that LEAPS options have at least one-year expiration dates.
LEAPS can be used to speculate on the direction of a stock or other security or to hedge against potential losses.
The long-term structure of LEAPS gives investors more time to generate profits and flexibility to adjust positions, but it also means the underlying security can move a lot over the contract’s life.
Another critical difference between LEAPS options and traditional options is that LEAPS options are usually only available on a limited number of stocks and other securities. There needs to be enough interest from investors to make them available.
Pros (and cons) of LEAPS
- Extended time frames can lead to more profits. When you buy an option, you're placing a bet on where the underlying security price will be in the future. With LEAPS options, you have a much longer time horizon, which means you can place bets on longer-term trends rather than guess where the market will be in the short term.
- LEAPS are less capital intensive than buying shares of stock. Many investors use LEAPS options as a synthetic alternative to a long equity position. LEAPS are a great way to initiate a poor man’s covered call and generate short-term income while holding the longer-dated option.
- Hedge portfolio assets. If you're worried about another security losing value, you can use LEAPS options to hedge against potential losses.
- Managing risk. One of the most significant advantages of LEAPS options is that they can help you manage risk. When buying LEAPS options, you can define the maximum downside risk at trade entry.
- LEAPS have more time for adjustments. Because of their long-dated expiration, LEAPS give you ample time to adjust your position if it goes against you.
- Pay attention to implied volatility. IV is a crucial factor impacting options prices. High implied volatility typically means higher options premium. Buying a long-term option when volatility is high may lead to a decrease in extrinsic value.
- Consider interest rates. Rho measures an option’s sensitivity to interest rates. Short-term options don’t generally warrant Rho consideration, but LEAPS may be impacted by rising or falling rates.
LEAPS vs. Short-term options
One of the key decisions when trading options is selecting an expiration (and a strike price). LEAPS and short-term options have their advantages and disadvantages, so it's essential to understand the critical differences before deciding.
- Short-term options have a lower premium than LEAPS options, so they are less expensive to buy.
- Short-term options are typically more liquid than LEAPS options, so finding buyers and sellers is easier.
- Short-term options have a shorter time frame, so there is less time for the underlying security to move in your desired direction.
- Short-term options are more sensitive to changes in external factors such as delta and gamma, so they can be more difficult to trade profitably.
- LEAPS options have a longer time frame, so there is more time for the underlying security to move in your desired direction.
- LEAPS options are less sensitive to the underlying’s price changes, and they decay slower than short-term options (theta).
- LEAPS options have a higher premium than short-term options, requiring more capital to trade.
- LEAPS options are less liquid than short-term options, so bid-ask spreads may be higher.
Ultimately, deciding which type of option to trade depends on your goals, preferences, portfolio, and risk tolerance.
Short-term options may be more suitable for traders looking for quick profits, while LEAPS options may be more suitable for traders looking to capitalize on a long-term trend.