What Are Long-Term Equity Anticipation Securities — LEAPS?

Long-term equity anticipation securities (LEAPS) are publicly traded options contracts with expiration dates that are longer than one year. LEAPS offer a buyer the right, but not the obligation, to purchase (call option) or sell (put option) the underlying asset at a predetermined price on its expiration date.

Understanding Long-Term Equity Anticipation Securities — LEAPS

Long-term equity anticipation securities are no different than short-term options except for the later expiration dates, which allow long-term investors to gain exposure to prolonged price movements.

As with many short-term options contracts, investors pay a premium or up-front fee for the ability to buy or sell above or below the option's strike price. The strike is the predetermined price at which the underlying asset is converted at expiry. For example, a $25 strike price for a GE call option would mean an investor could buy 100 shares of GE at $25 at expiry. Each options contract equates to 100 shares of the underlying asset.

The premiums for LEAPS are higher than for standard options in the same stock because the further out expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.

LEAPS also allow investors to gain access to the long-term options market without needing to use a combination of shorter-term option contracts. Short-term options have maximum expiration dates of one year. Without LEAPS, investors who wanted a two-year option would have to buy a one-year option, let it expire, and simultaneously purchase a new one-year options contract. The process, called rolling contracts over, would expose investors to market changes in the prices of the underlying asset as well as additional option premiums. LEAPS provide the longer-term trader with exposure to a prolonged trend in a particular security with one trade.

Key Takeaways

  • Long-term equity anticipation securities are ideal for options traders looking to trade a prolonged trend.
  • LEAPS can be applied to a particular stock or an index as a whole.
  • LEAPS are often used in hedging strategies and can be particularly effective for protecting retirement portfolios.

How Equity LEAPS Work

Equity LEAPS call options allow investors to benefit from potential rises in a specific stock while using less capital than purchasing shares with cash up-front. In other words, the cost of the premium for an option is lower than the cash needed to buy shares outright. Similar to short-term call options, LEAPS calls allow investors to exercise their options by purchasing the shares of the underlying stock at the strike price. Investors may sell the LEAPS calls at any time prior to expiration. However, the difference in premiums between the purchase and sale prices can lead to a profit or loss.

LEAPS puts provide investors with a long-term hedge if they own the underlying stock. Put options gain in value as an underlying stock's price declines potentially offsetting the losses incurred for owning shares of the stock. For example, an investor who owns shares of XYZ Inc. and wishes to hold them for the long term might be fearful that the stock price could fall. The investor could purchase LEAPS puts on XYZ to hedge against unfavorable moves in the long stock position.

LEAPS puts help investors benefit from price declines without the need to short sell shares of the underlying stock. Short selling involves borrowing shares from a broker and selling them with the expectation that the stock will fall by expiry. At expiry, the shares are purchased, and the position is netted out for a gain or loss. However, short selling can be extremely risky if the stock price rises instead of falling leading to losses.

How Index LEAPS Work

Equity index LEAPS are also available. Similar to equity LEAPS, index LEAPS allow investors to hedge and invest in indices such as the Standard & Poor's 500 Index (S&P 500), tracking the entire stock market or specific industry sectors. Index LEAPS allow investors to take a bullish stance using call options or a bearish stance using put options. Investors could also hedge their portfolios against adverse market moves with index LEAPS puts.

Pros

  • LEAPS offer investors the ability to gain from buying or selling stocks in the long-term

  • LEAPS put options can be used to hedge a long-term holding or portfolio

  • LEAPS are available in equity indices such as the S&P 500

Cons

  • LEAPS have costlier premiums than short-term options contracts

  • LEAPS may take a long time to realize a profit thus tying up the investment amount

  • LEAPS sold before their expiration can incur losses due to the difference between the purchase and sale prices

Real World Example of LEAPS

Let's say an investor holds a portfolio of securities, which primarily includes the S&P 500 constituents. The investor believes there may be a market correction within the next two years. As a result, the investor purchases index LEAPS puts on the S&P 500 Index to hedge against adverse moves.

An investor buys a December 2021 LEAPS put option with a strike price 3,000 for the S&P 500 and pays $300 up front for the right to sell the index shares at 3,000 on the option's expiration date.

If the index falls below 3,000 by expiry, the stock holdings in the portfolio will likely fall, but the LEAPS put will increase in value helping to offset the loss in the portfolio. However, if the S&P rises, the LEAPS put option will expire worthless, and the investor would be out the $300 premium.