For investors looking beyond traditional stock purchase and sale, options are a useful alternative. These allow an investor to be in the market and dabble in stocks without having to bring in a large capital. Also, with options, the risk can be lower as they are a form of hedging rather than outright purchase of equity.
But with the advent of LEAPS, the idea of options get more power and flexibility given their unique characteristics and advantages they bring to the investor’s table.
So what exactly is this new age form of options and does it tick the right boxes for you?
We take a closer look here at LEAPS.
What Are LEAPS?
LEAPS, short for Long term Equity Anticipated Securities, are a type of options with a longer shelf life than conventional ones. They are publically traded options contracts with a forward-looking date. The time factor is the main difference between LEAPS and the traditional options offered in the market. Otherwise, the concept is the same though the extended duration results in some consequent changes.
Typically, options are seen as short term instruments with a maturity window spanning between a month to a couple of months or more. Anyone looking for a prolonged duration from one year to three years needs a solution that allowed for an extension of the holding period. This is where LEAPS comes in.
These originated as long term exchange traded options in 1990 at the CBOE (Chicago Board Options Exchange). With an expiry date greater than a year to three years, these listed options contracts are ideal for those with a longer holding horizon. LEAPS are available for investment in a single stock or for investment in an index, on the whole.
LEAPS have been popular in multiple investment strategies such as hedging where it can be used to hedge against a position you have gone long on. Also, it can be used as an investment solution to other specific requirements like securing retirement portfolios, using index trading as a protective measure.
Let us Understand the LEAP Strategy with an Example
Mr X wants to buy a number of shares of Company 123. The current price of one unit is $10.00. Mr X has $10,000 to invest. He is optimistic that Company 123 will grow within a year or two and wants to remain invested in the stock. There are three options that Mr X can follow.
Option 1 – Mr X can purchase the stock outright
Mr X can buy 1000 shares at the current unit price, i.e., $10.00 for $10,000. However, he would lose the entire amount if the stock crashes.
Option 2 – Mr X purchases the stock on margin
Mr X can pledge the shares and leverage himself to a 2 to 1 ratio. Here, the investment goes up to $ 20,000 (2000 stocks) with an offsetting debt of $10,000. If the pledged stock crashes or if he gets a margin call, then he would be forced to sell his stocks at a loss. He would also have to pay the interest for the privilege of borrowing that extra money on margin.
Option 3 – Mr X purchases LEAPS
The third option reduces direct exposure to the stock market volatility. The pricing tables published by the Chicago Board Options Exchange (CBOE) will tell traders whether they can purchase a call option for a particular company. A call option allows a trader to purchase the underlying futures contract at the strike price any time before the contract expires.
If Company 123 expires two years from now, with a strike price of $15.00, Mr X has the right to buy at $15.00 per share at any time between the purchase date and the expiration date. He must pay a fee, or premium, for this option.
If Mr X decides to buy 100 contracts, he is exposed to 10,000 shares using LEAPS. This is because the call options are sold in contracts of 100 shares each. If Mr X chooses the premium option, say for example, $1.50 per share, the total amount would be $15,000.
Mr X, then, has the right to buy it at $15.00 per share, and as he paid $ 1.50 per share for that his breakeven point is $16.50 per share.
However, if the stock trades between $15.01 and $16.50 per share when the option expires in two years, you will lose some capital. If it trades below the strike price, you will have a 100% loss of capital. You can close out your position if the stock does rise substantially.
Read Also: How Much Money Do I Need To Trade Stocks?
Difference between LEAPS and Stock Buying
When investing through the LEAPS route, the requirement for capital is much lesser as compared to buying shares outright. This means the profit you can make is much more significant too.
Here are other differences that can be seen through a list of advantages and risks between LEAPS and other conventional tools like buying of stocks and traditional forms of options.
Advantages
✅ LEAPS are fairly widely offered across a range of stocks that opens up more opportunities. Since its introduction, the idea has been gaining in popularity which has been evident from the wider basket of stocks that can be bought with this strategy.
✅ LEAPS are used for a longer duration and, therefore, the extended period they are held for allows for more possibilities for appreciation. In cases where a prolonged period of staying invested is required, this route is ideal in comparison to conventional forms of options.
✅ The longer holding period also makes it easier and more possible to sell these options. Again, an extended duration helps get more opportunities for offloading these investments that could be difficult with regular options that have a shorter window of holding.
✅ The tendency for prices to go through multiple stages of highs and lows are more in a longer duration of holding. From a risk standpoint, this is beneficial as this greatly reduces the risk from price variance.
✅ When compared to conventional investment tools, the rate of erosion in value is slower in the case of LEAPS.
Check Out: 7 Top Long-Term ‘Millionaire-Maker’ Stocks To Buy
Risks
❌ Compared to conventional options, LEAPS can be limited in its availability across stocks. While the coverage is getting wider across the spectrum, not all stocks still are available with this type of option.
❌ The price at which LEAPS options, with their longer term duration, trade can be higher when compared with other investment options of a shorter term holding period. This increases the premium an investor has to pay that, in turn, results in a higher capital outflow for the purchase.
❌ The long holding duration means the invested capital could stay locked in for a prolonged period. Unlike a stock that is purchased through the regular route, selling it and offloading the investment is not possible.
❌ When compared to traditional stocks, a LEAPS transaction still carries an expiry date. It cannot be held interminably like a stock and this is particularly unsuitable in cases where the stock price is increasing and you are unable to benefit from the profit from it.
❌ There is an increased propensity for prices to fluctuate against market phenomena like changes in interest rates or any developments that result in volatility. The adverse changes in the market or in the performance of companies can impact the holding value and the rate of returns.
Sum-up
LEAPS can be an invaluable alternative to conventional investment tools that are available in the market. But it must be used judiciously and will give benefits only if used for the purposes it best serves.
The ideal usage is for investors and traders with experience and the knowledge to use it strategically. With a long term horizon and access to investible funds, those using LEAPS should be willing to also risk their capital.
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