In options trading, the short-term nature and volatility can deter people who prefer a longer-term investment horizon. This is where LEAP (Long-term Equity Anticipation Securities) options come into play. LEAP options offer an opportunity for long-term investors to trade options with a longer expiration date than traditional options.
With expiration dates up to three years in the future, LEAP options offer you the opportunity to benefit from the potential price movements of underlying assets, while maintaining the advantages of a long-term investment strategy. In this post, we’ll explore the concept of LEAP options, their advantages, and several popular trading strategies to help you make informed decisions in your investing journey.
What Are LEAP Options
LEAP options, or Long-term Equity Anticipation Securities, are a type of options contract with longer expiration dates than traditional options. The most distinguishing feature of LEAP options is their long-term expiration dates. While traditional options typically have expiration dates ranging from a week to a few months, LEAP options can have expiration dates up to three years in the future.
Due to their extended expiration dates, LEAP options often have a lower risk exposure compared to traditional options. As you have more time to react to market fluctuations, you can adjust your positions accordingly and potentially limit your losses. Furthermore, the extended time frame allows for a greater probability that the underlying asset will reach the desired strike price, making the investment more likely to be profitable.
An Example of a Leap Option Trade
Let’s say it’s March 2023, and you’re bullish on the long-term prospects of AMD with a current price of $100 per share. To gain exposure to the stock’s potential price increase without investing the total amount required to purchase 100 shares which would be $10,000, you can buy a LEAP call option.
You find a LEAP call option with a strike price of $110, expiring in January 2025, trading at a premium of $24 per contract. Each contract represents 100 shares of AMD, so the total cost of purchasing this option would be $2,400.
In this example, you have the right to buy 100 shares of AMD for $110 per share before the option expires in January 2025. For instance, if AMD’s stock price rises to $200 per share by January 2025, the intrinsic value of your LEAP call option would be $90 per share ($200 – $110). At this point, the option contract would be worth at least $9,000 ($90 x 100 shares), resulting in a potential profit of $6,600 ($9,000 – $2,400).
However, if AMD’s stock price remains below the strike price of $110 by the expiration date in January 2025, the LEAP call option would expire worthless, and you would lose the entire $2,400 premium paid.
Advantages of LEAP Options Trading
Capital efficiency
LEAP options can be a capital-efficient way to invest in the market, as they often require a smaller initial investment compared to purchasing the underlying asset directly. By using LEAP options, you can gain exposure to the price movements of a particular asset with less capital outlay, freeing up funds for other investments or diversification within your portfolio.
Portfolio diversification
Incorporating LEAP options into an investment portfolio can provide an additional layer of diversification. This is particularly beneficial for long-term traders seeking to create a well-rounded investment strategy that balances risk and return.
Leveraging potential
LEAP options offer you the potential to leverage your investments and potentially achieve higher returns. Since the initial investment required to purchase a LEAP option is often lower than buying the underlying asset outright, you can control a larger position with a smaller amount of capital. This leverage can amplify gains if the underlying asset performs well, providing the potential for larger returns relative to the initial investment.
Hedging opportunities
Another advantage of LEAP options is their potential use as a hedging tool. You can use LEAP options to protect your existing positions or portfolios from adverse market movements. For example, purchasing a LEAP put option can help to protect a long position in the underlying asset, providing downside protection in case the asset’s value declines. Similarly, a LEAP call option can be used to hedge against the risk of missing out on potential upside gains in a particular asset.
“Using leap options can lower your risk”
Popular LEAP Options Trading Strategies
LEAP Call Options
LEAP call options can be used for bullish bets on a stock or as a hedge against short-term downside risk.
Use cases for LEAP call options include:
- Speculating on a stock’s long-term potential.
- Hedging a short position in the underlying stock.
- Reducing the cost basis for a long stock position.
Potential risks and rewards
The primary risk associated with LEAP call options is the potential for the option to expire worthless, resulting in a total loss of the premium paid. This can occur if the stock price fails to rise above the strike price before the expiration.
The rewards of LEAP call options can be significant, as they offer leveraged exposure to the underlying stock. If the stock price rises substantially, the value of the LEAP call option can increase exponentially, resulting in outsized gains relative to the initial investment.
LEAP Put Options
LEAP put options can be used to profit from a potential decline in a stock’s price or as a hedge against a long position in the underlying stock.
Use cases for LEAP put options include:
- Speculating on a stock’s long-term decline.
- Hedging a long position in the underlying stock.
- Generating income through the sale of LEAP put options.
Potential risks and rewards
The primary risk associated with LEAP put options is the potential for the option to expire worthless, resulting in a total loss of the premium paid. Put options carry the same risks as call options except that when selling put options there is limited downside which can be great for strategies like the wheel strategy.
Vertical Spread With LEAPs
A vertical spread with LEAPs involves buying and selling two options with the same expiration date but different strike prices. The strategy can be implemented with either LEAP call options or LEAP put options.
Use cases for vertical spreads with LEAPs include:
- Reducing the cost of a long LEAP option position.
- Limiting the risk associated with a short LEAP option position.
- Exploiting a specific directional view on the underlying stock.
Potential risks and rewards
The risks and rewards of a vertical spread with LEAPs depend on the specific options used. Generally, the maximum potential loss is limited to the net premium paid or received, while the maximum potential gain is limited to the difference between the strike prices, less the net premium.
LEAP Covered Call Writing
LEAP covered call writing involves owning the underlying stock and selling a LEAP call option against it. This strategy aims to generate income from the premium received and can provide a degree of downside protection for the stock position.
Use cases for LEAP covered call writing include:
- Generating income from a long stock position.
- Reducing the cost basis of a stock position.
- Providing limited downside protection for a stock position.
Potential risks and rewards
The primary risk associated with LEAP covered call writing is the opportunity cost of capping the stock’s upside potential. If the stock price rises above the call option’s strike price, you will not participate in further gains.
The rewards of this strategy include the premium received and any potential capital appreciation in the underlying stock, up to the strike price of the sold call option.
LEAP Diagonal Spread
A LEAP diagonal spread involves buying a LEAP option and selling a shorter-term option with a different strike price. This strategy combines elements of a vertical spread and a calendar spread, aiming to profit from both time decay and directional movement of the underlying stock.
Use cases for LEAP diagonal spreads include:
- Generating income from a long LEAP option position.
- Exploiting a specific directional view on the underlying stock.
- Reducing the cost of a long LEAP option position.
Potential risks and rewards
The risks and rewards of a LEAP diagonal spread depend on the specific options used. Generally, the maximum potential loss is limited to the net premium paid, while the maximum potential gain depends on the difference between the strike prices and the time decay of the short option.
Conclusion
Overall, LEAP options offer a variety of strategies from speculation and hedging to generating income and reducing costs. By leveraging the flexibility of LEAP options, you can tailor your exposure to various market scenarios and adjust your strategies as market conditions change.
