Why LEAPs Are the Best Long-Term Options Strategy You Haven’t Tried Yet

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Long-Term Anticipation Securities (LEAPS) are option contracts designed for long-term investors. They are just like normal option contracts, except that they have expiration dates longer than a year. These option contracts are publicly traded, just like normal option contracts. 

LEAPS came in the year 1990. LEAPS has been in use as a long-term derivative instruments since then. Generally, these contracts can expire anywhere between 1-3 years. 

Investors prefer LEAPS for long-term investments because the time decay in these securities is much slower. LEAPS contracts also let investors own and control a more significant amount of underlying stock without actually owning it. This is why many investors use LEAPS as a stock replacement strategy. These option contracts are ideal for option traders looking to ride longer trends. 

What Are LEAPs in Options Trading?

Long-term Equity Anticipation Securities (LEAPS) contracts are long-term options designed especially for investors. LEAPS have an expiration period of 1-3 years. Investors prefer LEAPS in options trading for effective hedging and long-term speculation.

LEAPS option contracts provide a great way to ride in an underlying stock’s trend for the long-term. They are similar to short-term option contracts in every way except LEAPS are commonly used by investors due to its qualities. 

Investors deploy common option strategies using LEAPS whenever they expect momentum in an underlying stock in the long term, as the option contract does not decay much because of its long-term expiry.

How LEAPs Work in Options Trading

LEAPS strategies are similar to regular option strategies, with the key difference being that LEAPS have longer expiration dates. Investors prefer LEAPS because time decay impacts these options less.

Following is an example of how investors use LEAPS – 

Suppose an investor has Rs.10,000 to invest in a stock named ABC ltd., the ABC ltd. stock is priced at Rs.100 per share. The investor will only be able to buy 100 shares of ABC Ltd if he buys them directly. Furthermore, the investor will only gain 50% on his entire investment in case the stock rallies up to 50% in the coming year. 

Another option to consider can be buying a LEAPS contract of that stock. The same investor can buy a LEAPS contract of that stock for Rs.50 per contract. Now, the value of the LEAP option will jump to Rs.100 per contract if the same stock rallies 50% in the coming year. 

The investor doubles his investment amount when buying LEAPS when compared to buying stocks directly. 

Call LEAPs

A LEAPS call option allows investors to benefit from the underlying stock’s price increase at a lower cost compared to purchasing the stock directly. Meaning, an investor will have to invest less amount when buying a LEAPS call option contract rather than buying shares of the underlying stock directly. 

LEAPS call options can be exercised before expiry, just like any standard option contract, allowing the investor to buy shares at the option’s strike price.

Another benefit of a LEAPS call option is that it lets the holder of the contract sell the option at any time before the expiration. 

Put LEAPs

A put LEAPS option contract is commonly used for hedging if the option holder owns the underlying stock also. The LEAPS put option acts as a safety net when the stock price falls. This option contract helps investors in offsetting the loss incurred from owning the underlying stock. 

Let’s take an example for better understanding – 

Imagine an investor who has bought a stock named XYZ for the long-term is afraid that the price of this stock will fall in the coming months. The same investor can then buy a LEAPS put option to offset the potential loss from the temporary correction in the stock’s price. 

LEAPS put option contracts to help investors benefit from a price decline in the underlying stock without short-selling the stock. 

How to Trade LEAPs?

Trading LEAPS requires a solid understanding of the stock’s long-term trend. LEAPS differ from standard options because they are long-term contracts.

You can either buy or sell a contract of your choice by looking it up on an option chain If you want to trade using LEAPS. The longer the expiry, the higher the contract will be valued because these options have more extrinsic value. 

Additionally, you should know about these 2 things before placing a trade order with LEAPS  – 

1. Option Greeks: 

Option Greeks such as theta, vega, gamma, delta and rho have an influence on the option’s price.  As LEAPS expire after a long term, this extended timeframe means the option’s value is more sensitive to changes in factors such as  implied volatility, interest rates, and price fluctuations of the underlying stock.

2. Payoff Diagram:

A Payoff Diagram is a chart which shows the maximum risk/reward an option contract has. In a  LEAPS option’s payoff diagram, the risk is limited to the capital invested but the profit is unlimited. 

Here is an of trading with LEAPS:- 

Mr. A wants to buy a LEAPS call option. The above Payoff Diagram shows his maximum risk and reward. Meaning, if he purchases a LEAPS call option with a strike price of Rs. 100 for Rs. 20, the maximum loss he can incur will be Rs. 2000. While, the profit potential is unlimited as show in the image. 

However, the underlying stock must exceed Rs. 120 to realize a profit. 

Here is another example depicting a different scenario:

Mr. B who has recently bought shares worth Rs.1 lakh of a company named ABD limited for the long-term is now afraid of a potential market correction. He fears that the investment he made in the underlying stock will get hit as the result of this potential market correction. 

Mr. B buys LEAPS put option of ABD limited to offset his potential loss. Now, whenever the price of ABD’s shares falls, Mr. A is benefiting from the price rise in the LEAPS put option. 

His worry is gone as he knows that he has made a good investment and the stock will continue to appreciate in value in the long-term. He has offset his short-term losses by trading LEAPS put options. 

What are the Popular LEAPs Trading Strategies?

There are 3 popular LEAPS trading strategies. Investors and traders use these 3 popular LEAPS trading option strategies: 

1.Buying LEAPs Calls as a Stock Replacement

Many investors buy the LEAPS call option as a stock replacement. Here is an example for better understanding. 

Let’s consider a scenario where an investor wants to invest ₹50,000 in a highly volatile stock, XYZ Ltd. The current price of XYZ stock is ₹100 per share.

If the investor buys XYZ shares directly, he can purchase 500 shares (₹50,000 / ₹100 per share). Assuming the stock price rises by 20% to ₹120 per share, the profit would be:

Profit = (500 shares * (₹120 – ₹100)) = ₹10,000

Instead, the investor could buy LEAP call options on XYZ with a strike price of ₹100 and an expiration date of 1 year. Let’s assume the LEAP call option premium is ₹5 per share. The investor can buy 100 LEAP call contracts (1 contract = 100 shares) for a total investment of ₹5,000 (₹5 per share * 100 contracts). If the stock price rises by 20% to ₹120 per share, the LEAP call option will be in-the-money.

The profit on the LEAP call option would be:

Profit = (100 contracts * (₹120 – ₹100 – ₹5)) = ₹1,500 per contract

Total profit = ₹1,500 per contract * 100 contracts = ₹150,000

In this case, the investor would have made a significantly higher profit (₹150,000) on his investment of ₹5,000 in LEAP call options compared to the profit of ₹10,000 he would have made by buying the stock directly. 

2. Using LEAPs Puts for Long-Term Hedging

Investors use LEAPS to put option contracts in place to hedge against the potential price drop in the stocks they own. Here are 2 scenarios that show how LEAPS put options are used for

Long-Term Hedging – 

Let’s say you’re a long-term investor in a tech stock, XYZ Ltd and your buying price is ₹1,000 per share. You’re worried about a possible market crash that could send XYZ’s stock price plummeting.

You buy a LEAPS put option on XYZ with a strike price of  ₹900 to protect your investment. This option contract will expire in one year and the option premium is ₹50 per share.

Scenario 1: Stock Price Falls Below Strike Price

If the stock price drops to ₹800, your put option is now in-the-money. You can exercise the option and sell your shares at the strike price of ₹900, limiting your loss to the premium paid (₹50).

Scenario 2: Stock Price Falls Below Strike Price, but You Hold the Put Option

You can hold onto the put option until its expiration date instead of exercising the option right away. If the stock price remains below ₹900 at expiration, the put option will be exercised automatically, and you’ll receive the difference between the strike price and the stock price.

The LEAPs put option acts as a safety net, protecting your investment from significant losses. You can benefit from the rise in the put option’s value as the stock price falls, even if you don’t sell your shares.

These 2 scenarios depict a very common methods traders/investors use for long-term hedging. 

3.LEAPs in Covered Call Strategies

A LEAPS Covered call is a strategy wherein an investor sells a LEAPS call option of a stock that they already own. Here is an example of how LEAPS covered call option strategy works – 

Mr.A invested in a stock named XYZ at Rs.100 a year ago. XYZ’s current market price is Rs.150. Mr.A has invested Rs.50,000 in this stock as a long-term investment, but his analysis says that the stock has a potential chance of returning to Rs.125 in the coming 2-3 months. 

In this case, Mr.A can sell his shares immediately and book a profit of Rs.50 per share, or he can deploy a covered call strategy using LEAPS. 

A covered call strategy will require Mr.A to sell an Out-of-the-Money (OTM) LEAPS call option. Considering Mr.A sells the LEAPS call option at a strike price of Rs.150, there are three possible scenarios that could play out – 

1. XYZ continues to go higher from Rs. 150 price level and Mr. A’s covered call strategy ends up in a loss. 
2. XYZ goes sideways for the next 2-3 months. In this case, Mr.A will not be earning any profit nor will he incur any loss. 
3. XYZ’s stock price declines below Rs.150 level as Mr.A predicted, and he ends up making a profit from his covered call strategy. 

How to Buy LEAPs Option?

Buying LEAPS options is similar to buying normal option contracts. Here are 4 things you should do in order to buy LEAPS options – 

1. Open a brokerage account:

Having a brokerage account is a must for trading and investing in the market. Make sure that your broker lets you buy LEAPS option contracts. 

2. Research: 

The researching part mainly involves studying and building an overall view about the market. Look at the option chain after analyzing and selecting the stocks you wish to take an entry in. You will have to search for option contracts having an expiration date of more than 1 year for identifying LEAPS options. 

3. Select the LEAPS option you wish to buy: 

Select the LEAPS call/put options with the appropriate expiry and strike price. You will also have to take a look at the open interest, volume and option greeks at the time of selecting the right LEAPS option contract.

4. Execute the order:

Similar to buying a normal option contract, select the strike price you wish to buy and enter the quantity. Click on “BUY” to complete the order. 

What are the Differences between LEAPs & Regular Option?

The differences between LEAPS and regular option contracts range from time duration to expiration. Here are 3 critical differences between LEAPS and regular option contracts – 

• Time Horizon and Expiration: 

LEAPS option contracts expire in a range from 1 to 3 years, while normal option contracts expire in a month in India. This increased time duration makes LEAPS a more lucrative choice for investors looking to ride larger trends in stocks. Investors can utilize LEAPS in a much more efficient manner in the long run. LEAPS offers a variety of benefits such as long-term hedging, an alternative to buying stocks directly, a lengthy expiry of options and long-term option strategies such as covered calls. 

• LEAPs Premiums: Why They Are Higher: 

LEAPS option premium costs more than a standard option contract. LEAPS options are expensive because they expire in a span of 1-3 years unlike standard options. Longer expiration time gives investors the chance of catching a move in the underlying stock and making profits. 

• LEAPs Theta Decay: 

Theta Decay is the process of an option losing its value over time as it comes near to its expiration date. LEAPS options experience time decay at a slower rate compared to standard options, making them suitable for long-term strategies because of longer expiration periods. This is why LEAPS option contracts experience slow theta decay and are more suitable for longer-term strategies.

What are the Benefits of Trading LEAPs? 

LEAPS option contracts offer multiple benefits ranging from long-term speculation to flexibility of hedging. Here are 3 important benefits of trading LEAPS – 

• Long-Term Speculation with Leverage: 

LEAPS lets investors speculate in underlying stocks for long-term with low investments. LEAPS generally expire in 1-3 years timeframe. They experience less theta decay as a result which makes them best suitable for long-term speculation. Leverage makes trading LEAPS with less capital accessible to everyone. 

• Lower Capital Requirement: 

LEAPS also acts as a stock replacement instrument. Meaning, buying LEAPS is more affordable than buying the underlying stock outright due to its low capital requirement. This makes LEAPS a lucrative choice among investors in the market. 

• Flexibility for Hedging: 

LEAPS provide a great way to hedge against existing long or short positions in your portfolio. For example, an investor with a long-term position can buy a LEAPS put option to offset his potential loss due to the potential decline in his underlying stock. 

What are the Risks Involved in Trading LEAPs? 

LEAPS option contracts come with a variety of associated risks, such as volatility and time decay. Here are 3 crucial risks involved in trading LEAPS: 

• Higher Premiums and Capital Outlay: 

Buying LEAPS will cost you more than buying standard option contracts. LEAPS have higher premiums compared to normal options because they have longer expiration periods. The risk of losing more money is higher in LEAPS as you need to invest more money upfront. 

• Time Decay and Opportunity Cost: 

Generally, LEAPS options face a slower rate of time decay but it still erodes the value of option contract if the underlying stock does not move as expected. Furthermore,  holding LEAPS can tie up a portion of your capital for a significant period. An investor could have utilized that capital by investing somewhere else thus leading to an opportunity cost. 

• Volatility Risk (Vega):

Vega is a measure of an option’s sensitivity to the changes in volatility in its underlying stock. LEAPS options are more sensitive towards volatility as these contracts are long-term and there is more time for volatility to affect the price of underlying stock. 

How does Option Greeks affect LEAPs?

Understanding option greeks and its effects on the pricing of LEAPS is crucial. Option greeks are mathematical variables that reflect the sensitivity of an option’s price to changes in different underlying factors.They help investors/traders in measuring potential risk and reward. 

Delta Sensitivity in LEAPs

Delta is an option greek which measures the rate of change in an option’s price for a 1-point change in its underlying stock. Delta sensitivity is higher in LEAPS options. 

For instance, if a LEAPS call option has a delta of 0.5, the option price will rise by Rs. 0.50 for every Rs. 1 increase in the underlying stock.

LEAPS are more Delta-sensitive when compared to normal option contracts. This is because the rate of time decay is slower in LEAPS until the contract is near expiry. Until then, any move in the underlying stock results in the LEAPS option moving significantly in the same direction. 

Theta in LEAPs: Time Decay Over the Long Term

Theta in LEAPS options represents the time decay of a contract’s value as the expiry approaches. LEAPS option contracts experience time decay at a much slower rate when compared to standard options. 

Standard options in India have a maximum expiration period of a month, whereas a LEAPS option contract’s expiration period ranges from 1 to 3 years. 

For example, a LEAPS put option with a theta of -0.10 will lose Rs.0.10 in value each day if no other variables change.

Vega and LEAPs: Impact of Volatility

Vega in LEAPS represents the rate of change in an options price due to changes in implied volatility. Vega plays a crucial role in the price changes that happen everyday in LEAPS option as these contracts are highly vega sensitive. 

LEAPS options have an increased risk due to volatility when compared to standard options. This is because LEAPS options are traded for extended periods of time and are susceptible to everyday volatility for more time. 

A high vega reflects that the option contract will be highly sensitive to the price moves in its underlying stock. For example, if a LEAPS call option contract’s vega is 0.15, a 1% change in the implied volatility will affect a Rs.0.15 increase in the option’s price.

Rho and LEAPs: Interest Rates Impact 

Rho is an option greek that reflects an option’s sensitivity to changes in interest rates. Rho has a larger impact on LEAPS compared to standard options, as these contracts are traded for extended periods of time. 

For example,  If a LEAPS call option has a Rho of 0.05, it means that the option’s price will increase by Rs.0.05 for every 1% increase in interest rates. This change is an absolute increase in the option’s price.

Can LEAPs Expire Worthless?

Yes, LEAPS options can expire worthless if there is no move in the underlying stock just every other option contract. The expiry of option contract will make it worthless if stock price remains below the strike price of a LEAPS call option and vice versa. 

Are LEAPs Better for Long-term Investors?

Yes, LEAPS options are better for long-term investors than short-term option contracts. LEAPS are better, especially for those looking to leverage market movements. LEAPs have a longer expiration period than standard options. This allows investors to maintain their positions for an extended period, which gives them more time for the underlying stock price to move in their favour.

Also, LEAPs offer leverage, which means that investors can control a larger amount of the underlying asset with a relatively small investment. Lastly, LEAPs can be used for various investment strategies, including speculation, hedging, and income generation.

Do LEAPs Pay Dividends Like Stocks?

No,  LEAPS do not entitle the holder of dividends. Although LEAPS are commonly used as a way to replace the act of buying stocks directly. 

When to Close LEAPs option?

You can close a LEAPS option contract any time before they expire. Keeping track of your positions and constantly monitoring them is a key to closing a LEAPS option successfully.