LEAPS function the same as a single-leg call or put option but have much longer maturities. Buyers have the right, but no obligation, to exercise an option before expiration. Sellers are obligated to the terms of the contract if assigned the options position. In many ways, LEAPS are similar to holding a long-term position in a stock, but with defined risk and much lower capital allocation. LEAPS strategies are similar to short-term options strategies but often favor buying strategies over selling strategies because of the slower rate of time decay. LEAPS are bought and sold like their short-term counterparts, and can have American or European-style expirations. LEAPS can be used in conjunction with other options strategies to define risk, hedge a position, or reduce the LEAPS contract’s cost basis.
LEAPS behave exactly like short-term options, but with a much longer time horizon. They can be used individually to generate income, speculate on future price movement, or to hedge against potential risk in other options or stock positions. LEAPS can also be combined with other option contracts to create multi-leg strategies. The primary benefit of using LEAPS options is the reduced capital allocation required to enter a position relative to owning or shorting stock for the same extended period of time. Furthermore, the downside risk is clearly defined at entry and limited to the premium paid.
For example, if an investor wanted to own 100 shares of a stock trading for $100, the initial capital required to enter the trade would be $10,000, all of which would be at risk if the underlying asset fell to $0. Similar exposure via a LEAPS call option would come at a fraction of the capital outlay. LEAPS can also be sold to collect credit. They can be used with short or long term options contracts to create cost-effective and risk-defined strategies, or combined with stock to hedge the position. LEAPS are used in place of stock shares in strategies that combine stock ownership with short options contracts, like covered call writing.
LEAPS are initiated like any other options contract. An investor may buy-to-open (BTO) or sell-to-open (STO) a position by selecting a contract from the options chain. The main difference is the expiration date must be at least one year in the future to qualify as a LEAPS contract. The longer time until maturity will naturally equate to much higher pricing, as the options will have significant extrinsic value.
The Greeks (Delta, Gamma, Vega, Theta, Rho) play a large role in the option’s pricing, as the extended timeframe means the option’s value is more sensitive to changes in implied volatility, interest rates, and price fluctuations of the underlying stock.
LEAPS Payoff Diagram
The payoff diagram for purchasing a single-leg LEAPS contract will resemble the same profit and loss potential as a long call or long put option. The risk is limited to the initial debit paid at entry and profit potential is unlimited. The cost to enter a long LEAPS contract will be much higher than shorter-term options because of the longer time until expiration. This will impact the break-even points, which will be much farther from the strike price. The math remains the same: to be profitable, the stock price must be beyond the strike price plus the debit paid.
For example, if a long call option with a strike price of $100 is purchased for $20.00, the maximum loss is defined at -$2000 and the profit potential is unlimited if the stock continues to rise. However, the underlying stock must exceed $120 to realize a profit.
If a LEAPS call or put contract is sold, the initial credit received is still the maximum potential profit for the trade. In this scenario, much more credit will be collected than with shorter-term options, and the break-even range will be much larger. However, when selling naked options, the risk beyond the premium collected is undefined.
If multiple LEAPS are bought or sold to create multi-leg strategies, the payoff diagrams will be the same as the short-term strategy.
Entering LEAPS is the same as entering short-term options contracts. The premiums and related relevant information will be available on the options chain. The options may be bought or sold or combined, just like any other options contract. The most significant difference will be the pricing relative to short-term options. LEAPS will have more expensive premiums, but that is the compromise for having capital-effective, long-term exposure to stocks.
Exiting LEAPS is the same as exiting short-term options contracts. If the option has American-style expiration, the position may be closed anytime before expiration by reversing the initial entry order. For example, if a long call was purchased to initiate the position, it will be sold to exit. If it is sold for more than it was purchased, a profit will be realized. American-style options can also be exercised prior to expiration. If the option has European-style expiration, exiting the position or early exercise is not a possibility. The option will be cash-settled on the expiration date.
Time Decay Impact on LEAPS
Time decay will have a minimal impact on a LEAPS extrinsic value for the majority of its lifetime. Time decay, or theta, increases exponentially as an option approaches the expiration date. Typically, the effects of time decay will not significantly impact the option’s pricing until the last 60 days before expiration. Because LEAPS have at least one year of time value, theta is a significant component of the contract’s extrinsic value. The more time until expiration an option has, the more opportunity the underlying asset has to experience price movement, and the more expensive the option's price.
Implied Volatility Impact on LEAPS
Implied volatility has the potential to impact LEAPS significantly. If implied volatility increases substantially before expiration, the long options contract will benefit. Conversely, implied volatility can have an adverse effect on an option’s premium. If volatility contracts before expiration, the price of the long contract will decrease. Implied volatility, or vega, is impossible to predict and is relative, so what seems low currently may not be in the future.
LEAPS can be adjusted like any options contract. For the duration of the contract, additional positions may be added to define risk, increase credit, or hedge against adverse price movement. Because a LEAPS contract has so much time until expiration, investors may choose to wait to make adjustments.
LEAPS can be rolled if the option is approaching expiration and is still not profitable. However, the original pricing will be a large determinant in adjusting the contract for credit or debit. If the underlying stock price has moved dramatically away from the profit target, or implied volatility has experienced large changes, it may be difficult to roll the position in a cost-effective manner. Many factors will play a role in the decision to roll LEAPS as expiration approaches, but the mechanics are the same as adjusting any options strategy.
Because of the long-dated maturity of LEAPS, short-term contracts are often sold against long LEAPS positions. The short-term contracts may then be rolled from expiration period to expiration period to generate income, such as with a synthetic covered call strategy.
Because LEAPS have a long lifespan, the ability to hedge the position, or use the option to hedge other positions, is beneficial for the investor. LEAPS are often used to hedge existing long-term positions.
For example, if an investor has made the decision to hold a stock for many years, a long-dated put option may be purchased to hedge against future risk. Stock positions and options strategies can also be used to hedge LEAPS as well. The extended timeframe of LEAPS contracts allows the investor a lot of flexibility in creating risk defined hedges or finding potential for more profit.
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