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There is one options trading strategy that, with an initial duration of up to 39 months, gives investors more time to realize a profit or minimize losses when needed.
This strategy also offers greater leverage than traditional equity options or futures contracts, making them a popular risk management tool for traders.
We’re talking about LEAPS options.
What are LEAPS options, and are they right for your investment portfolio?
In this article, we'll explain:
- What LEAPS options are, along with examples
- LEAPS call options vs LEAPS put options
- How to buy LEAPS options
- How to exit LEAPS options
- And more
Let’s get started!
What are LEAPS Options?
LEAPS options (Long-Term Equity Anticipation Securities) are a type of equity option that investors can use to gain leverage on an anticipated upturn from an underlying asset such as a specific company's stock price or an index fund.
LEAPS options give the holder the right (but not the obligation) to buy or sell shares of a specific stock at a fixed strike price after the expiration date — usually up to approximately three years from the purchase date.
Advantages of LEAPS Options
- Provides leverage that can act as an excellent hedge against any drastic move in the market
- Offers more flexibility and stability than typical options
- Generates a better ROI (return on investment) than holding stocks long term
- Taxed as long-term capital gains when held for at least one year and one day
Disadvantages of LEAPS Options
- Higher premiums than typical options due to the lengthy amount of time remaining until expiration
- Investment funds are tied up for a long time
- Slightly complicated for the typical retail investor
Example of LEAPS Options
LEAPS Call Options
Let’s say an investor believes the stock of XYZ company will substantially increase above its current price of $200 within the next few years.
The investor could buy a LEAPS call option for December 2024 at a $300 strike price, approximately 24 months into the future.
If the LEAPS option price is $50, the investor will have up to two years to reach their desired profit target.
Many smart investors look for option contracts with a 0.8 Delta, meaning that the options trader profits $80 for every dollar the underlying asset increases.
This presents an attractive discount on the stock price for the options seller and a worthwhile profit for the options seller.
This also creates a scenario where the options trader earns a higher return on investment with fewer upfront costs than the stock trader.
If the price does not reach the target within the duration of the contract, the investor can pay a small cost to roll the contract forward to a future expiration date.
They can also sell the contract immediately to minimize losses.
LEAPS Put Options
Conversely, let’s say the investor believes the stock of XYZ company will substantially drop within the next few years.
The investor could buy a LEAPS put option for the same expiration and a $100 strike price.
If the LEAPS options price is $50, the investor would collect the premium and have two years to reach their profit target or wait until the contract expires worthless, allowing them to keep the entire premium.
Just like the call options example, LEAPS put options can also be rolled forward to an expiration date in the future.
Traders may also decide to cut their losses and move on to the next trade.
LEAPS Options Bonus Tips
Options are more expensive when implied volatility is higher.
Therefore, the best time to buy LEAPS options is when implied volatility is low (also known as Vega).
This also means that it is better to sell LEAPS options when implied volatility is high.
When selling LEAPS put options, time decay tends to increase the closer it gets to expiration.
Trading volume is another vital factor to consider when trading LEAPS options.
While long-term expirations are good for LEAPS options, if there is little to no trading volume, it may be best to stay away from trading that specific option.
How long are LEAPS Options Contracts?
LEAPS options are designed to provide investors with a longer-term investment opportunity.
Unlike regular options, LEAPS options contracts can expire anywhere between 6 and 39 months.
LEAPS options have a longer expiration date, providing more opportunities to manage price fluctuations of the underlying asset.
How to Buy LEAPS Options
Similar to conventional options, LEAPS options can be purchased to open or close a trade.
There are two main ways to buy LEAPS options:
- you can trade them directly through your brokerage account
- you can buy them through an exchange like the Chicago Board Options Exchange (CBOE)
The main advantage of buying them via an exchange is that you'll get access to a broader range of options that aren't available through your brokerage.
The main disadvantage is having to pay higher commissions than buying them directly from your brokerage.
How to Exit LEAPS Options
Just like with short-term options, when you exit a LEAPS option trade, it's essential to pay attention to the expiration date.
This is because any options contract can expire worthless if there's not enough time left until the expiration date.
To ensure you exit a LEAPS option trade before the expiration date, you can place stop orders to close the trade before the expiration date.
This is done to take profits early once they hit a predetermined target or to minimize losses if the market makes a strong move in the wrong direction.
The Bottom Line: Leaps Options
Trading LEAPS options can be a low-maintenance way to invest in the market.
When properly managed, they can provide a consistent long-term return on investment.
To accomplish this, experienced options traders tend to roll losing trades forward to allow more time to reach their profit targets.
This positions traders to better protect their investments and maximize the opportunities for future profits.
If you look at the American economy since its inception, it has continued to grow overall despite short-term periods of economic loss.
This is why LEAPS options on index funds are more reliable than LEAPS options on individual stocks.
However, LEAPS options on individual stocks have a higher chance of providing astronomical returns as opposed to LEAPS options on index funds.
Trading LEAPS options is a fantastic way to manage risk.
They provide a reliable option for traders looking for long-term investment strategies that do not require constant management.
LEAPS options are best suited for long-term investors looking for long-term capital gains and the tax benefits that come with them.
These investors typically have time on their side and are not concerned about short-term fluctuations in the market affecting their investments.
After gaining experience trading options and using different options trading strategies, exploring LEAPS options may be a worthwhile progression.
Do yourself a favor and make the time to discover how LEAPS options can fit into your current investment portfolio.
Free Options Trading Resources
Above all, ensure that you are continuing to learn about the complexities of options trading.
Here are a few free resources that can help you do just that: