LEAPS Options Explained

Most traders think of options as only short-term contracts, but the truth is that some investments do not fit in the usual trade window, which is where LEAPS options come in.

Short for Long-Term Equity Anticipation Securities, these options have highly extended expiration dates, reaching up to two or three years into the future.

Understanding LEAPS Options

By nature, LEAPS share all the same features and characteristics of standard options. The only differentiating feature is the extended expiration date, typically more than 12 months away.

As well as with standard options, LEAPS contracts are available on a wide range of stocks, ETFs and major market indices, and are traded on the same exchanges, either through a put or a call option.

LEAPS calls give you the right, but not the obligation, to buy the underlying asset at a predetermined strike price before expiration.

LEAPS puts give you the right to sell under the same conditions.

Most LEAPS on equities are American-style options, meaning they can be exercised at any point up until the expiration date. 

Each contract still represents 100 shares of the underlying asset, just like regular options.

The main difference here is in their time horizon. A LEAPS contract can run up to about 2 years and 8 months into the future, which dramatically affects its pricing, time decay, and sensitivity to a number of market factors.

How LEAPS Options Work

The mechanics of LEAPS mirror those of shorter-term options, but their longer lifespan changes their behavior in subtle but important ways.

Time Value and Decay

Because LEAPS have much more time until expiration, they carry higher time value premiums. 

In the early life of the contract, theta decay, which stands for the erosion of value as expiration approaches, is relatively slow. But in the final months, that decay accelerates sharply.

This is why many traders prefer to use LEAPS for long-term exposure and roll them forward before time decay becomes too steep.

Volatility Sensitivity

LEAPS are more sensitive to changes in implied volatility than near-term options. 

A rise in volatility can increase their value significantly, while a drop can erode premiums quickly. This sensitivity is measured by vega, which is typically larger for longer-dated contracts.

Directional Exposure

Deep in-the-money LEAPS calls often behave similarly to holding the stock itself, because their delta, or the measure of how much the option’s price moves for each $1 move in the underlying asset, can approach 1. 

Out-of-the-money LEAPS, however, need more substantial price moves to become profitable.

Interest Rates and Dividends

Because LEAPS stretch over multiple years, interest rates and dividend expectations play a larger role in pricing. 

Rising interest rates usually increase call premiums, while anticipated dividends can lower them.

Advantages of LEAPS

These contracts are used by traders for several key reasons, namely:

Lower Capital Requirements

The main benefit of LEAPS contracts is that they require far less capital than you’d need if you opted for purchasing the equivalent number of shares outright.

Built-In Leverage

Another big advantage of LEAPS is that they can offer significant leverage. This means that even with a generally low investment, a strong price move can lead to much larger gains than you’d have without leverage.

Defined Downside

When you purchase a LEAPS contract, the maximum risk you open yourself to is to lose the premium you paid. This is true no matter how the market moves, which is why many experienced traders opt to trade this way.

Hedging Flexibility

Some investors also use LEARS put to protect their long-term stock positions, without having to sell their shares. As LEAPS are by nature long-term contracts, this can serve as downside protection over extended periods.

Risks and Drawbacks

Despite their advantages, LEAPS are not without downsides.

If you’re considering them, it’s important to understand what can go wrong.

For starters, LEAPS carry more time value, which makes them more expensive than near-term options. They also come with liquidity concerns, as long-term options have lower trading volume with wider bid-ask spreads, potentially making the entering and exiting positions more costly.

Another downside here is that by holding LEAPS, you do not get dividends or voting privileges like you’d have as a shareholder.

Lastly, LEAPS are more sensitive to macroeconomic factors, making any shifts in interest rates or implied volatility potentially highly costly.

Popular LEAPS Strategies

LEAPS can be used in many different ways, from simple bullish bets to complex hedging techniques. Here are the five most commonly used trading strategies:

Long Call LEAPS

Buy a LEAPS call to gain long-term bullish exposure without tying up large amounts of capital. This is a popular alternative to buying shares directly.

Protective Puts

Buy a LEAPS put against a long stock position to lock in a floor price for your shares over a year or more. This strategy functions like insurance for your portfolio.

Poor Man’s Covered Call

Purchase a deep in-the-money LEAPS call, then sell short-dated calls against it. 

This creates income-generating potential similar to a covered call strategy but with far lower capital requirements.

Rolling LEAPS

As expiration nears, roll the LEAPS forward by closing the current position and opening a new one with a later expiration. 

This allows you to maintain long-term exposure without suffering steep time decay.

Index LEAPS

Investors can also use LEAPS on broad market indices to express macroeconomic views, hedge entire portfolios, or gain leveraged exposure to market trends.

In Conclusion

As you can see, LEAPS options provide you with a rare ability to combine the flexibility and leverage of options trading with long-term market views. By nature, they can be a powerful tool in hedging and market speculation, but they do also come with some unique risks and higher premiums, as well as liquidity challenges.

If used strategically, however, LEAPS can be a way to position yourself for the future, with precision and control.