LEAPS: Explained

BY TIO Staff

|July 29, 2024

Long-term Equity Anticipation Securities (LEAPS) are a type of options contract with expiration dates that are longer than one year. They are a popular investment tool for traders and investors who seek to leverage their positions or protect their investments over a longer period. This article delves into the world of LEAPS, explaining their intricacies, benefits, and potential risks.

LEAPS are often used as a cost-effective way to control shares of an underlying stock for a specified period without the need to buy the stock outright. They are a versatile tool that can be used for a variety of strategies, including hedging, income generation, and speculative trading. Let's dive deeper into the world of LEAPS and understand how they can be used in the trading landscape.

Understanding LEAPS

LEAPS are essentially long-term options contracts. Like any other option, a LEAPS contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) before the contract's expiration date. The difference lies in the duration of the contract. While standard options typically have expiration dates up to one year, LEAPS can have expiration dates up to three years in the future.

The longer duration of LEAPS provides more time for the underlying asset's price to move in the holder's favor. This makes them an attractive tool for investors who have a long-term view on a particular asset. However, like all options, LEAPS also come with risks, including the potential loss of the entire premium paid for the contract if the price of the underlying asset does not move as anticipated.

Types of LEAPS

There are two types of LEAPS: calls and puts. A LEAPS call gives the holder the right to buy the underlying asset at the strike price before the expiration date. If the price of the asset rises above the strike price, the holder can exercise the option to buy the asset at the lower strike price, thereby making a profit. If the price of the asset falls below the strike price, the holder can let the option expire worthless, limiting their loss to the premium paid for the contract.

A LEAPS put, on the other hand, gives the holder the right to sell the underlying asset at the strike price before the expiration date. If the price of the asset falls below the strike price, the holder can exercise the option to sell the asset at the higher strike price, thereby making a profit. If the price of the asset rises above the strike price, the holder can let the option expire worthless, limiting their loss to the premium paid for the contract.

Benefits of Trading LEAPS

LEAPS offer several benefits to traders and investors. First and foremost, they provide leverage. This means that a relatively small investment can control a significantly larger amount of an underlying asset. This leverage can amplify profits, but it can also amplify losses, so it's important to use it wisely.

Another benefit of LEAPS is their potential for risk management. By purchasing a LEAPS put, an investor can protect their portfolio from a significant drop in the price of the underlying asset. This is known as a protective put strategy. Similarly, by selling a LEAPS call, an investor can generate income from the premium received, while potentially being prepared to sell the underlying asset if its price rises above the strike price. This is known as a covered call strategy.

LEAPS and Volatility

LEAPS are also sensitive to changes in volatility. This is because the price of an options contract is influenced by the expected volatility of the underlying asset. If the expected volatility increases, the price of the options contract will also increase, and vice versa. This means that traders can potentially profit from changes in volatility by trading LEAPS.

However, it's important to note that volatility can be a double-edged sword. While it can amplify profits, it can also amplify losses. Therefore, it's crucial to have a solid understanding of how volatility affects options pricing before trading LEAPS.

Risks of Trading LEAPS

While LEAPS offer several benefits, they also come with risks. One of the main risks is the potential loss of the entire premium paid for the contract. This can happen if the price of the underlying asset does not move in the holder's favor before the expiration date. In other words, if a LEAPS call holder does not exercise their option because the price of the underlying asset is below the strike price, or if a LEAPS put holder does not exercise their option because the price of the underlying asset is above the strike price, they can lose the entire premium paid for the contract.

Another risk of trading LEAPS is the potential for increased losses due to leverage. While leverage can amplify profits, it can also amplify losses. This means that if the price of the underlying asset moves against the holder's position, they can potentially lose more than the premium paid for the contract. Therefore, it's important to use leverage wisely and to have a solid risk management strategy in place when trading LEAPS.

LEAPS and Time Decay

LEAPS are also subject to time decay, which is the decrease in the value of an options contract as it approaches its expiration date. This is because the likelihood of the option being in the money (i.e., profitable) decreases as the expiration date approaches. However, because LEAPS have longer expiration dates than standard options, the effect of time decay is less pronounced. Nevertheless, it's still an important factor to consider when trading LEAPS.

Time decay can be a disadvantage for LEAPS holders, especially if the price of the underlying asset does not move as anticipated. However, it can also be an advantage for those who sell LEAPS, as they can potentially profit from the decrease in the value of the contract as it approaches its expiration date.

Conclusion

LEAPS are a versatile tool that can be used for a variety of trading strategies, including leverage, income generation, and risk management. However, like all trading instruments, they also come with risks. Therefore, it's crucial to have a solid understanding of how LEAPS work and to have a robust risk management strategy in place before trading them.

By understanding the intricacies of LEAPS, traders and investors can potentially leverage their positions, protect their investments, and generate income over a longer period. However, it's important to remember that successful trading involves not only understanding the tools at your disposal but also using them wisely and responsibly.

Start Trading LEAPS with TIOmarkets

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Risk disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Never deposit more than you are prepared to lose. Professional client’s losses can exceed their deposit. Please see our risk warning policy and seek independent professional advice if you do not fully understand. This information is not directed or intended for distribution to or use by residents of certain countries/jurisdictions including, but not limited to, USA & OFAC. The Company holds the right to alter the aforementioned list of countries at its own discretion.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.