Trading and Hedging With Long-Term Options [LEAPS]

Long-term Equity AnticiPation Securities (LEAPS) let option players make long-term bets on the price action of a stock or index

Dec 23, 2016 at 1:01 PM
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    Long-term Equity AnticiPation Securities, also known as LEAPS, are options with longer lifespans than typical options, with expiration dates between one and three years in the future. While traders can buy and sell LEAPS in the same way as standard monthly options, LEAPS also come with their own set of advantages and drawbacks.

    LEAPS are generally considered a less-risky alternative to weekly and standard monthly options, mostly because there is more time for the desired price action to take place. The time decay of the option occurs at a slower rate, so the delta of LEAPS tends to be higher than standard options. This allows LEAPS to behave similarly to the underlying stock, but purchasing LEAPS requires a smaller initial investment than purchasing shares of a particular equity -- in other words, they provide leveraged profit potential compared to stock ownership.

    Of course, LEAPS do have some distinct drawbacks as well. For one, LEAPS aren't available on every optionable stock. For those stocks that do have LEAPS available, traders may often find that the reward for playing LEAPS is less than the reward for paying near-term options, due to the decreased rate of time decay. Of course, the benefits of owning shares of an equity -- such as dividends and voting rights -- are also forfeited when an investor chooses to go the LEAPS path.

    Let's look at an example of how LEAPS can be a good alternative to stock ownership for long-term bulls. If a trader is optimistic about Stock XYZ, which is currently trading at $105, but she doesn't want to pay the initial cash outlay of $10,500 necessary to own 100 shares of XYZ, she can instead purchase a January 2019 100-strike call option for $15, or just $1,500 (since it controls 100 shares). Since the options are already in the money by 5 points, the option likely sports a favorable delta -- in this example, assume the delta is 0.75, or 75%. This means for every single point move higher by XYZ, the LEAPS call should increase in value by $0.75. So, for just 15% of the initial cost of outright ownership of the shares, the LEAPS player is realizing 75% of the rewards. On the flip side, if the shares tank, the LEAPS player's losses are limited to the initial premium paid -- or just $1,500 -- even if XYZ falls to $0.

    LEAPS can also be used as portfolio protection, especially if a trader wants to hedge against sector-specific or broad-market headwinds with index LEAPS. Index LEAPS allow traders to invest in an entire sector, or market index, and purchasing a LEAPS index put can work the same way as purchasing a protective put, but on a bigger scale.

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