LEAPS (Long Term Equity Anticipation Security) is simply the name given to options that have an expiration of 9 months or longer. LEAPS provide a more cost-effective way of gaining long term exposure to stocks. The average S&P 500 stock has more than doubled in the last decade. This means that more capital is required to purchase 100 shares of an underlying stock. Beginner investors with less capital can use LEAP options as an alternative to buying 100 shares of a stock.

When to use LEAPS

There are 2 types of LEAPS - calls and puts:

Call LEAPS

A call LEAP is mainly used as a replacement strategy for long stock as it offers long term upside exposure. Call LEAPS should be used when there is a bullish outlook on the underlying stock or ETF that will probably last 2-3 months.  LEAPS are also a great way to mitigate downside risks. When the market is believed to be overbought or the rally is extended with no significant pullbacks, the probability of a market correction becomes higher. LEAPS allow for upside exposure even if there is a market correction in the short run. 

Put LEAPS

Puts LEAPS are used less than calls and are generally used for hedging purposes. Buying a put LEAPS option offers downside protection against long positions in either individual stocks or a portfolio of stocks. Put LEAPS should only be used for long term bearish outlooks (1-2 months) where markets will correct by 20% or more. 

Bullish Leaps Example

Assume stock $XYZ is currently trading at $100 per share and has a bullish sentiment. Let's compare buying the stock vs. buying a call. 

Buying stock:

• Buy 100 shares @ $100 per share = $10,000
• Max reward = unlimited
• Max risk = $100 per share (the amount paid for the stock)

Buying Call Option (In-the-money):

• Buy $85 call for $25
• Max reward = unlimited
• Max risk = $25 per share

In this case, the call LEAPS allowed for maintaining upside exposure while reducing the risk and total cost of the trade when compared to buying the stock outright.

Bearish Leaps Example

Assume stock $XYZ is currently trading at $100 per share and has a bearish sentiment. Let's compare shorting the stock vs. buying a put. 

Shorting stock:

• Short 100 shares @ $100 per share = $10,000
• Max reward = $100 per share
• Max risk = Unlimited (as there is unlimited upside)

Buying Put Option (In-the-money):

• Buy $115 put for $25
• Max reward = $90 per share
• Max risk = $25 per share

In this case, the put LEAPS allowed for maintaining downside exposure while reducing the risk and total cost of the trade when compared to shorting the stock outright.

Benefits of LEAPS

LEAPS offer an improved risk profile when compared to buying or shorting a stock. As there is a cap on risk when buying LEAPS, the risk profile is asymmetrical (unlimited profit potential but limited losses) while still maintaining dollar for dollar exposure on a stock's movements. As LEAPS are very long term, the effects of time decay (Theta) are minimized. Because Theta is very low with LEAPS, "In the Money" options have a lower extrinsic value.

Limitations of LEAPS

LEAPS are generally less liquid than front month options. Therefore, it is only viable to use LEAPS for longer term investing instead of short-term trading. When deciding whether to use LEAPS or to buy the stock, one should consider whether the stock is a dividend paying stock. Because LEAPS do not pay dividends, investors seeking to take advantage of dividend paying stocks may prefer buying the stock instead of using LEAPS. Furthermore, LEAPS are not available on all stocks - 2500 stocks, ETF's and indices have LEAPS.

Understanding LEAPS

In-the-money LEAPS offer a better profit potential and exposure than Out-of-the-money LEAPS. Even though OTM LEAPS have less risk, it is important to remember that LEAPS are used as a replacement to buying and holding the stock for a long period of time. Therefore, an investor that uses LEAPS would want to maximize the capital appreciation of the stock by using ITM LEAPS.

Trading Tips

• Expiration selection - Expirations should be greater than 9 months as this minimizes time decay.
• Strike selection - Buy In-the-money strikes (70-80 delta). This will usually cost between 20-30% of the underlying stock price.
• Better for non -dividend paying stocks
• Entry strategy - Enter with long term bullish outlook 
• Exit strategy - Exit before expiration and set up stop loss and take profit prices based on stock price.
• Sell "Poor man's Covered Call" to further reduce risk

"Poor Man's Covered Call"

This refers to selling covered calls without owning the underlying stock. Selling calls against the long LEAP replaces the stock position. By methodologically selling covered calls during the lifetime of the LEAP, a trader can collect around 5% of the underlying LEAP call in a single month. This reduces the cost basis of the LEAP by anywhere between 20-50%. However, it is important to remember to roll the short call instead of assignment as this may result in having to buy stock or exercising the LEAP to deliver the shares. 

Summary

LEAPS provide a great way to gain similar long-term exposure to the capital appreciation of a stock while capping the risk. Due to the large amount of capital required to buy 100 shares of a stock outright, LEAPS have become a popular tool for investors that have less capital. When trading LEAPS, use the trading tips in this post to maximize their effectiveness.