What Are Long-Term Equity Anticipation Options?
LEAP options are simply option contracts with expiration dates that are one year or longer in duration. Other than the length of the expiration date being 1 year plus, they are technically and functionally the same as other listed options.
If you remember from our option trading 101 article, an option contract grants the buyer the right (but not the obligation) to buy or sell (dependent upon the option being a call or a put), the underlying asset at a predetermined price (strike) on or before a specific date (expiration).
If LEAP options are the same functionally as regular options, then why would a trader or long-term investor use LEAP options?
There are several reasons, such as:
- Long term investors looking to use options to trade a long-term trend
- To hedge a long or short position in your portfolio
- To control shares in the underlying while having a lesser margin requirement
- To have a lesser price sensitivity to changes in the underlying security
Hence, there are several reasons a long-term stock trader or investor should consider LEAP options as an alternative to buying the stock outright.
Now when you compare LEAP options vs short-term options, a few advantages stand out, such as:
- LEAP options suffer less from Theta decay (time) because they have more time to accomplish their objectives
- LEAP options act more like the underlying security due to delta being higher vs short term options
However, LEAP options also have some disadvantages vs short-term options, including:
- Higher premiums
- Lessor availability (lower volumes)
Thus, when considering to use a LEAP option vs buying the underlying security, it’s important for option traders and investors to consider the pros and cons of LEAP options.
We also mentioned using LEAP options to hedge as they can be an effective tool for doing so. For example, let’s say you own 1000 shares of Microsoft (Nasdaq: MSFT) at the start of the new year, but you’re concerned about an increase in volatility in the stock, and a significant potential pullback in the price of the stock (20% or greater).
Currently, MSFT is trading for $280 per share (as of July 21st, 2021) and you think the stock can lose 20% of its value over the next year and want to protect your stock position in Microsoft, but don’t want to close out your position should it fall 20% or more. This is where you may want to consider a LEAP option (in this case, a put) with an expiration date 1 year out (July 22’).
A 20% decline in the stock would change its price from $280 to $224 per share, thus creating a risk of $56 per share x 1000 shares, so a $56,000 decline in your portfolio.
However, the Jul 22 puts at $280 are pricing at $20.50 (theoretically) which means for $20.50 x 10 option contracts (1 contract = 100 shares, so 10 contracts = 1000 shares), or $20,500, you can own a put option that will gain in value if the price of Microsoft falls over the next year.
Hence for a much lower price, you can hedge (or protect) your long stock position buying put options on MSFT. So, while you will be losing money on your stock position, you’ll be gaining money on your long puts, thus ‘hedging’ your long stock position.
This is one of the many ways long-term investors and option traders can use LEAP options.
Another potential strategy for using LEAP options is to buy index LEAP’s, which will give you exposure to the index while not technically owning any of the stocks in the index.
There are many reasons to consider using LEAP options, whether as an investment strategy, to get exposure for less margin, or for hedging, long-term investors and option traders should consider using LEAP options for their portfolio.
LEAP options have been some of my most profitable trades over the last few years (20’, 21’), and I’ll continue to use them both as a trader and long-term investor.
To learn more about calls, puts, and trading options, make sure to check out our option trading 101 article.