The Pros and Cons of Trading LEAPS in Your Portfolio

LEAPS typically have higher deltas than shorter-term options

Managing Editor
Jan 5, 2018 at 4:44 PM
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    LEAPS, or Long-term Equity AnticiPation Securities, are options with expiration dates set as far as three years into the future. They possess all the same characteristics as standard options, just with a much longer shelf life. Below, we will discuss the advantages and disadvantages of LEAPS vs. short-term options, compare buying LEAPS calls to traditional stock ownership, and look at ways to hedge with these long-term options.

    LEAPS vs. Short-Term Options

    The primary difference between LEAPS and standard weekly or monthly options is time. Because there is more time for the predicted stock move to play out, LEAPS suffer less from time decay. And, since time decay doesn't begin to accelerate until expiration draws closer, the delta of LEAPS is higher than near-term options. This means LEAPS behave more closely to the underlying stock.

    However, the added time value also makes LEAPS more expensive than shorter-term options with the same strike. Since option buyers' maximum risk is the initial premium paid, LEAPS buyers are risking more capital out of the gate. In addition, LEAPS are not readily available for every optionable stock. 

    LEAPS vs. Stock Ownership

    As alluded to earlier, the higher delta of LEAPS options make them an attractive alternative to buying or shorting the shares outright, since they tend to move in near step with the stock price. Plus, buying LEAPS calls costs less than outright buying shares of a stock.

    For example, if Stock XYZ is trading at $100, a bullish speculator could purchase 100 shares for $10,000, or a January 2020 100-strike call for $12, or $1,200 (since each option represents 100 shares). If XYZ rallies to $120 before January 2020, the stock buyer's shares will be worth $12,000 -- a $2,000 gain, or a 20% return on investment. Meanwhile, the intrinsic value of the January 2020 100-strike call will be $20; minus the $12 paid to buy the option (and not including brokerage fees), that's a profit of $8, or $800 -- a 67% return on investment.

    However, by purchasing LEAPS calls instead of simply buying the stock, you forfeit shareholder benefits such as dividends and voting rights. In addition, the LEAPS buyer could suffer a much bigger percentage loss than the stock owner, should the underlying security take a turn for the worse. For instance, if XYZ fell to $90 by January 2020, the aforementioned call buyer would be staring at a 100% loss, while the shareholder would be looking at a 10% loss.

    Using LEAPS to Hedge

    Besides the traditional speculative options trading, LEAPS can be an effective tool for hedging. Shareholders can buy LEAPS puts to hedge against a long position they have. Index LEAPS can also be utilized as a large-scale protective put for your portfolio, or to hedge against sector-specific headwinds.

     

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