Buying Long-term Equity Anticipation Securities (LEAPS) can be a smart investment strategy for those looking to make a long-term bet on a particular stock or market. LEAPS are essentially long-term options contracts that allow investors to control a stock or index for an extended period of time, up to two or three years in some cases.
In this article, we will take a closer look at LEAPS, how they work, and provide some tips on how to use this investment strategy effectively. We will also explore some of the benefits and risks associated with buying LEAPS. Whether you’re a seasoned investor or just starting out, understanding LEAPS can help you make informed decisions about your investment portfolio.
What Are LEAPS?
LEAPS, or Long-Term Equity Anticipation Securities, are options contracts that give investors the right, but not the obligation, to buy or sell a stock or index at a predetermined price (known as the strike price) at any time up to two or three years in the future.
The primary difference between LEAPS and shorter-term options contracts is their extended expiration time. Most standard options contracts have an expiration date of one to nine months, while LEAPS have an expiration date of up to two or three years. This longer time frame can give investors more flexibility and the ability to make longer-term bets on the direction of a stock or index.
LEAPS also differ from shorter-term options contracts in terms of their premium. LEAPS contracts are typically more expensive than shorter-term options due to the extended expiration time and the potential for higher returns.
There are two types of LEAPS contracts: LEAPS calls and LEAPS puts. A LEAPS call gives the holder the right to buy the underlying asset at the strike price, while a LEAPS put gives the holder the right to sell the underlying asset at the strike price.
The primary advantage of buying a LEAPS call is that it allows an investor to profit from an increase in the underlying asset’s price over an extended period of time. If the underlying asset’s price rises above the strike price, the investor can exercise the option and buy the asset at the lower strike price, then sell it at the higher market price for a profit.
On the other hand, buying a LEAPS put can be useful for investors who want to protect their portfolio against a potential downturn in the market. If the market drops below the strike price, the investor can exercise the option and sell the underlying asset at the higher strike price, thereby limiting their losses.
Buying LEAPS Examples
Let’s say you’re bullish on the stock of Company XYZ, which is currently trading at $50 per share. You believe that the stock will rise significantly over the next two years, so you decide to buy a LEAPS call option with a strike price of $60 and an expiration date two years from now.
Assuming the premium for the option is $10 per share, you would pay a total of $1,000 for the option (since each options contract typically represents 100 shares of the underlying stock).
Over the next two years, if the stock of Company XYZ rises above the strike price of $60, you can exercise the option and buy the stock at the lower strike price, then sell it at the higher market price for a profit. However, if the stock does not rise above the strike price, the option may expire worthless and you would lose the entire premium paid for the option.
Let’s say you’re bearish on the stock of Company XYZ, which is currently trading at $50 per share. You believe that the stock will fall significantly over the next two years, so you decide to buy a LEAPS put option with a strike price of $40 and an expiration date two years from now.
Assuming the premium for the option is $8 per share, you would pay a total of $800 for the option (since each options contract typically represents 100 shares of the underlying stock).
Over the next two years, if the stock of Company XYZ falls below the strike price of $40, you can exercise the option and sell the stock at the higher strike price, then buy it back at the lower market price for a profit. However, if the stock does not fall below the strike price, the option may expire worthless and you would lose the entire premium paid for the option.
It’s important to note that buying LEAPS put options to profit from a bearish view can be a high-risk strategy, as it requires the stock to drop significantly in value over a relatively long time frame.
These are just simplified examples, and in reality, there are many factors that can affect the value of a LEAPS option, including changes in the stock price, volatility, and time decay.
How to Buy LEAPS
To buy LEAPS, follow these steps:
- Choose a brokerage: First, you’ll need to choose a brokerage that offers options trading, as not all brokerages do. Research and compare different brokerages to find one that meets your needs, offers competitive pricing, and provides the tools and resources you need to trade options.
- Choose a stock or index: Once you have a brokerage account, choose the stock or index you want to invest in using LEAPS options. You should have a solid understanding of the company or market and its long-term prospects before investing.
- Choose a strike price and expiration date: Determine the strike price and expiration date for the LEAPS option you want to buy. For a LEAPS call option, choose a strike price that is higher than the current stock price if you believe the stock will rise over the long-term. For a LEAPS put option, choose a strike price that is lower than the current stock price if you believe the stock will fall over the long-term.
- Place your order: Enter your order on your brokerage’s trading platform. Make sure to review your order carefully to ensure you are buying the correct option and entering the correct information, such as the number of options contracts you want to buy and the expiration date.
- Monitor your investment: After you’ve bought your LEAPS option, be sure to monitor it regularly to track its performance and make any necessary adjustments to your investment strategy. If the stock price moves in the desired direction, you may want to sell the option to realize a profit. If the stock price moves in the opposite direction, you may want to cut your losses and sell the option to minimize your losses.
Remember, buying LEAPS can be a high-risk, high-reward strategy, so it’s important to do your research and understand the risks and potential rewards.
How to Adjust LEAPS
Adjusting LEAPS involves making changes to your options position in response to changes in the underlying stock price or market conditions. Here are some ways to adjust your LEAPS position:
- Roll the option: If your LEAPS option is nearing expiration, you may want to roll it forward to a later expiration date to give yourself more time for the stock price to move in your favor. Rolling the option involves selling your current option and using the proceeds to buy a new option with a later expiration date.
- Sell options against your position: If you own a LEAPS call option, you may want to consider selling a covered call option against your position to generate additional income. If you own a LEAPS put option, you may want to consider selling a cash-secured put option against your position to generate additional income.
- Hedge your position: If you are concerned about potential downside risk, you may want to consider hedging your LEAPS position with other options or investments that can help to protect against losses.
- Close the position: If your LEAPS option is not performing as expected and you don’t see any potential for it to recover, you may want to consider closing the position and taking a loss. This can be a difficult decision to make, but it’s important to cut your losses and move on to other opportunities if necessary.
It’s important to remember that adjusting your LEAPS position can be complex, and it’s important to thoroughly research and understand the potential risks and rewards of each adjustment strategy before making any changes.
Pros and Cons of Buying LEAPS
Here are some potential pros and cons of buying LEAPS:
- Extended Expiration Time: LEAPS provide investors with an extended expiration time of up to two or three years, which gives them the flexibility to take a long-term view on a stock or index.
- Lower Cost: LEAPS are often less expensive than buying the underlying stock or index, which makes them a more affordable option for investors.
- Potential for High Returns: LEAPS can generate significant returns if the underlying stock or index rises significantly during the life of the contract.
- Limited Risk: The most an investor can lose on a LEAPS contract is the premium paid to purchase the option, which can help limit downside risk.
- Higher Premiums: The extended expiration time of LEAPS means that they often have higher premiums than short-term options, which can make them more expensive to purchase.
- Lower Liquidity: Because LEAPS have a longer lifespan, they may not be as actively traded as short-term options, which can result in lower liquidity and wider bid-ask spreads.
- Time Decay: LEAPS are subject to time decay, which means that their value decreases as they get closer to expiration. This can reduce the potential for returns if the underlying stock or index does not rise significantly during the life of the contract.
- No Dividend Payments: Unlike holding the underlying stock, LEAPS do not provide investors with any dividend payments, which can be a disadvantage for income-focused investors.
Overall, buying LEAPS can be a smart investment strategy for those looking to make a long-term bet on a particular stock or index, but it is important to understand the risks and limitations associated with this approach. As with any investment, it is important to do your research, set realistic expectations, and diversify your portfolio to manage risk.
The Bottom Line
In conclusion, LEAPS can be a valuable tool for investors who are looking to take advantage of long-term trends in the stock market while also managing their risk exposure. However, it’s important to keep in mind that buying LEAPS comes with its own set of risks, including the possibility of losing the entire premium paid for the option.
Before investing in LEAPS options, it’s important to carefully evaluate your investment goals and risk tolerance. With careful planning and a thoughtful approach, LEAPS can be a valuable addition to any investor’s portfolio.