LEAPS Options: What They Are and When to Use Them

The popularity of options trading has reached an all-time high, with a record 39 million total contracts traded in 2021. While options trading can be extremely profitable and rewarding, it is also risky for inexperienced investors. In fact, researchers estimate retail option traders lost a collective $1.14 billion during the COVID-19 pandemic from November 2019 through June 2021.

Long-term equity anticipation securities, or LEAPS, are a specific type of option contract designed to appeal to investors with a more long-term mindset than the typical day trader. The 2025 LEAPS options contracts began trading on Sept. 12, giving option traders their first opportunity to place bets about where their favorite stocks may be headed over the next two-plus years. But before any traders start buying or selling LEAPS options, there are a few things they must know:

— What are LEAPS options?

— LEAPS option strategies.

— Are LEAPS options right for you?

What Are LEAPS Options?

An option contract gives the buyer the right, but not the obligation, to buy or sell a specific amount of an underlying security at a set price at or before the contract’s expiration date. Each stock option contract gives the buyer the right to buy or sell 100 shares of the underlying stock. A call option contract is a contract to buy shares of stock, and a put option contract is a contract to sell shares of stock.

Despite the fancy name, LEAPS options are simply longer-term options that have expiration dates of at least 12 months into the future.

Imagine an investor has $500 to invest in a stock with the ticker XXX that he expects to rise between now and 2025. That investor can choose to buy shares of XXX stock or buy LEAPS call options for XXX stock. If stock XXX is currently trading at $10 per share, the investor can afford to buy 50 shares. If the share price then rises 25% by 2025, the trader would earn $125 on their stock investment.

But instead of buying 50 shares with that $500, that investor might choose to buy five LEAPS call options priced at $1 each with a strike price of $10. Because of their inherent leverage, the value of the LEAPS options would jump to $2.50 by 2025. Instead of a mere 25% return ($125), the investor is now sitting pretty on a 150% ($750) gain.

Jason Porter, senior investment manager at Scottish Heritage, says the leverage of LEAPS options is one of their most appealing qualities to investors.

“If you bet correctly on the direction of the shares, buying them enables you to utilize less capital than you would if you were buying stock, and they can produce huge returns,” Porter says.

As a result, LEAPS call buyers could potentially generate better returns than investors who hold a much larger position in the underlying stock.

“A rise of 50% might result in a gain of around 300%, but this strategy carries risks,” Porter says.

LEAPS Option Strategies

Making leveraged bets on stocks is only one of the ways investors commonly use LEAPS options.

Michael Ryan, retired financial planner and founder of MichaelRyanMoney.com, says buying LEAPS put options is a simple, effective way to hedge against a stock market sell-off.

“One way is to use LEAPS options as a way to hedge against a portfolio of stocks,” Ryan says.

“If the stock price falls, the value of the LEAPS put option will increase, offsetting some of the loss in the stock portfolio.”

For example, an investor with a diversified retirement portfolio of stocks may choose to buy a small number of LEAPS put options in the SPDR S&P 500 ETF Trust (ticker: SPY). These LEAPS options can serve as an insurance policy against a stock market crash. If the S&P 500 rises, these LEAPS options may expire worthless, but the losses from the LEAPS contracts would theoretically be dwarfed by the gains from the much larger retirement portfolio. If the market crashes, the leveraged nature of the SPY LEAPS contracts might help offset a significant portion of the losses from the overall portfolio.

In addition to speculation and hedging, LEAPS options can be a source of income for investors as well. Investors can sell covered LEAPS call options corresponding to long-term stock holdings in their portfolios. Option sellers get to keep the premium they collect from buyers when they sell option contracts regardless of whether or not those contracts are ever exercised.

Are LEAPS Options Right For You?

LEAPS options can provide portfolio flexibility and leverage for investors with a longer-term mindset than the typical options trader. Investors can use LEAPS options to make long-term bets on individual stocks with only a relatively small upfront investment. They can also use LEAPS options to construct complex trades that are sensitive to time or volatility. In addition, buying LEAPS put contracts can be a less risky way for bears to bet against a stock than short selling, which involves theoretically unlimited losses.

However, leverage also creates larger downside risk for LEAPS option investors. Anthony Martin, CEO and founder of Choice Mutual, says trading LEAPS is more complicated than trading stocks.

“While they are fairly low risk, if you don’t make your choices based on a detailed knowledge of the market then you risk wasting multiple years on an unprofitable investment,” Martin says.

In addition, the time value premium associated with LEAPS options can be fairly expensive given how far their expiration dates are in the future.

“LEAPS are more costly than many shorter term options,” Martin says.

[Read: What Is a Bespoke Tranche Opportunity?]

Because all options contracts are constantly approaching their expiration dates, their time-value premium is always declining. For LEAPS contracts, the time value premium can be so high that a stock may need to make a very large move in the right direction just to offset the time value decay and allow the investor to break even.

The leverage inherent in the entire options market make options extremely volatile relative to the stock market. This volatility can ramp up considerably as a LEAPS option contract approaches its expiration date, especially if the underlying stock’s price is close to the strike price of the contract. Finally, while it is extremely rare for stocks of blue-chip companies to go to $0, it’s extremely common for options contracts to expire out of the money and become completely worthless — so use options with caution.

More from U.S. News

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LEAPS Options: What They Are and When to Use Them originally appeared on usnews.com

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