Investors caught between whether to buy a stock or a short-term options contract might consider LEAPS®—Long-Term Equity AnticiPation Securities.
Although LEAPS are options contracts, they can take on stock-like characteristics
LEAPS are typically more expensive and less leveraged than short-term options, and they tend to incur time decay at a slower rate
Leverage works both ways (potential for strong returns, but also significant losses)
When it comes to selecting an investment type, investors have many possibilities—individual stocks, mutual funds, exchange-traded funds (ETFs), options, and futures, for example. Diversification, riskiness, complexity, and capital requirements may factor into that decision.
One of the most common choices an investor may find themselves faced with is the traditional stock investment strategy versus the more aggressive short-term options play, with stocks generally being considered the more conservative choice. Stocks may pay dividends, and the holding period for a stock is potentially unlimited. Additionally, a stock represents ownership in a corporation.
Options, on the other hand, are typically a more aggressive—and speculative—strategy. Option holders are not entitled to dividends from the underlying stock and are subject to time decay (“theta”) of a contract that will lose value due to the passage of time and eventually expire. But options do offer leverage—which many traders find attractive.
One possibility for investors caught between the decision to buy a stock or a short-term options contract is LEAPS—Long-Term Equity AnticiPation Securities. LEAPS are options contracts that mostly follow the same rules as short-term options, but because their expiration dates are as far as three years out, they can take on characteristics that are quite different from their short-term siblings.
Because of their long-dated expiration dates, LEAPS are typically more expensive and less leveraged than short-term options and tend to incur time decay at a slower rate. Although LEAPS can typically be traded freely throughout their life, the typical holding period for this investment is usually longer than that of a short-term option.
As a consequence, investors are more likely to evaluate the fundamental characteristics of the underlying stock for a LEAPS contract. Additionally, though short-term option traders may attempt to time their contract holding period to avoid earnings releases, that’s simply not possible if your holding period is several months or more.
Both call and put contracts are available for LEAPS, but given the general tendency of the market to increase over time, call LEAPS tend to be more popular and often have more open interest. But for the option trader who wants to take a bearish position on a company without actually shorting shares of the underlying stock, a LEAPS put may be the right choice.
For a bullish example, let’s look at a LEAPS call contract and compare it to buying 100 shares of the underlying stock.
For a stock trading at $62.42, 100 shares would cost $6,242. The risk is the full cost, and if the stock price increased by 20% over the next six months, the stock investment would gain 20% or about $1,065.
As an alternative, let’s say the initial cost for a $57.5 strike LEAPS call contract would be around $675. And although that may seem like an expensive options contract, it only amounts to about 11% of the cost of the stock purchase. With that 20% increase in the underlying stock, according to the theoretical price (“theo price”) tool on the thinkorswim® platform, the LEAPS put could theoretically be sold for $1,248 or a 158% increase (see figure 1). And if the stock were to instead fall by 20% over the same time period, the call would lose about 96% of the initial premium, or $650 (see figure 2).
FIGURE 1: THEORETICAL OPTIONS PREMIUM INCREASE. The theoretical price tool, available in any option chain on the thinkorswim platform, can show changes in the theoretical value of an option as inputs are changed. For illustrative purposes only.
FIGURE 2: THEORETICAL OPTIONS PREMIUM DECREASE. The theoretical price tool, available in any option chain on the thinkorswim platform, can show changes in the theoretical value of an option as inputs are changed. For illustrative purposes only.
Rather see the numbers in a table? See the summary below.
Of course, leverage works both ways, and a 20% decrease in the underlying stock would result in a much larger percentage decrease in the LEAPS contract. Furthermore, theta will adversely affect the LEAPS contract but leave the stock shares untouched.
In other words, a LEAPS contract will likely cost just a fraction of a stock purchase, and although the dollar movement on the LEAPS contract will not be as much as the stock, it’ll likely be a much larger percentage move, as illustrated in the table.
In this example, a 9-month contract was chosen, but if the anticipated holding period is longer, a longer-term contract should be selected. As with any options contract, LEAPS contracts are more expensive the further in the money (ITM) they are and the more time until expiration is purchased. Additionally, as with any investment, it’s important that the liquidity of the contract be considered before entering in.
So, what are some lessons that can be drawn from this look at LEAPS options?
First of all, though LEAPS are options contracts, they may be useful in a portfolio that’s partway between stocks and short-term options. In fact, you can think of LEAPS as a hybrid between the two. Investors will likely find the longer-term expiration date allows more flexibility than those associated with short-term options.
Similarly, the lower rates of time decay of LEAPS may take less of a toll on the contract price. (Remember: Just like any options contract, time decay accelerates as an option’s expiration gets closer.) The amount of leverage is likely less on LEAPS than on shorter-term options, but that may be exactly what an investor wants. Furthermore, although LEAPS may seem expensive compared to short-term options, they’ll probably seem cheap when compared to buying shares of the underlying stock.
As a general rule, the more ITM the LEAPS contract, the more stock-like qualities it will exhibit.
Secondly, as with most trades, have your exits in mind when you enter the trade. Because they have longer-dated expirations, LEAPS contracts will often be managed more like stock trades. Common exit considerations may be a broken stock support level, a target price being hit, or a stop order is triggered. It’s also important to keep in mind that LEAPS are options contracts that will eventually expire. Should the LEAPS position you purchase expire worthless, the entire investment in that position would be lost.
Finally, when choosing to use LEAPS calls or puts as a part of your trading strategy, consider their role in your whole portfolio. LEAPS are a type of options, so they could be used to fill a spot in the more aggressive portion of your portfolio. It’s easy to forget that leverage works both ways when you’re considering the benefits of the long-term leverage that LEAPS can bring.
Although LEAPS may not ultimately find a place in your portfolio, it’s worthwhile to know the possibilities so you can make an informed decision. As with any investment, educate yourself on their potential risks as well as their potential benefits.
To trade LEAPS, you’ll need to be approved for options trading. Higher options trading approval levels are required for certain strategies.
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
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Please note that the examples above do not account for transaction costs or dividends. Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade.
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