Finance

Long-term Equity Anticipation Securities (LEAPS)

Long-term Equity Anticipation Securities (LEAPS)

Long-term equity anticipation securities (LEAPS) are option contracts that have a much longer expiry period than standard options. The expiry period typically ranges from 1-3 years. They are derivatives that track the price of an underlying asset like stocks or indexes. The Chicago Board Options Exchange (CBOE) was the first to introduce LEAPS in 1990. The buyer in a LEAPS contract has the right but not the obligation to purchase or sell the underlying asset at a predetermined rate on or before its expiration date.

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Example:

A LEAPS contract grants investors to gain long-term exposure to prolonged price movements.

Suppose we say the strike price for a call option of XYZ company is $20. This means that the investor can buy 100 shares of XYZ company at $20 at expiry. If the market price is higher than the strike price, the investor will exercise the option. On the other hand, if the market price is lower than the strike price, the investor will not exercise the option and will have a loss of the premium. The brokerage and other costs will be deducted from the profit that is earned and will be added to the losses that are incurred.

Benefits:

  • Smaller capital investment: LEAPS call option grants the investor to gain from the potential rises in an underlying stock while using less capital than purchasing shares with cash upfront.
  • Longer expiry: LEAPS has a longer expiry period which leaves a bigger window wherein the underlying assets price can move. This can indicate a higher potential for the option to be profitable.
  • Time value: Because of their longer expiry period, LEAPS lowers in value more slowly than traditional options. Thus, the prices are less sensitive to the passage of time. The holder of a LEAP calls contract can sell the contract any time before expiration.
  • Hedging: Investors can use LEAPS to hedge a long-term holding or portfolio. It gives investors a long-term hedge if they own the underlying asset.
  • Equity indices: An investor can also purchase LEAPS on equity indices.
  • Accessibility: LEAPS contract grants investors accessibility to the long-term options market without requiring them to use a combination of short-term option contracts.

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Drawbacks:

  • Costly premiums: The premiums of LEAPS are costlier than traditional options because of the longer expiry period.
  • Less liquidity: Because of their longer time frame, LEAPS has lesser liquidity as the money is tied up for a longer period.
  • Adverse movements: The movements of markets or companies can be adverse and can bring about huge losses if wrongly predicted. Short-selling can extremely risk as it will result in huge losses if the price keeps on rising instead of falling.
  • Volatility: LEAPS can be listed on a stock or an index and the prices are more sensitive to changes in volatility and interest rates.
  • Risky: Trading in a LEAPS contract should be done only by the most experienced and financially stable investors as it is attached with more risk.

Final Thoughts:

Long-term equity anticipation securities (LEAPS) are option contracts that range from 1-3 years. LEAPS are options with longer expiration periods than standard options on many equities and indices. The contract holder has the rights but not the obligation to purchase or sell the underlying asset at a specific time. They are best suited to investors who are more stable can effectively employ strategic trading and can afford to put up substantial capital. LEAPS are frequently used in hedging strategies. While dealing in a short-sell in LEAPS contract it is strongly recommended to maintain a stop-loss as this will minimize the potential losses.

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

 

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