What are the long-term equity securities – LEAPS?
Long-term advance equity securities (LEAPS) are publicly traded option contracts with expiration dates greater than one year. As with all option contracts, a LEAPS grants a buyer the advantage, but not the necessity, of buying or selling – depending on whether the option is a call or a put – the underlying asset predetermined price no later than its expiration date.
Long-term anticipation securities are no different from short-term options, except for later expiration dates. Longer lead times allow long-term investors to be exposed to prolonged price movements.
As with many short-term option contracts, investors pay a premium – an initial charge – for the opportunity to buy or sell above or below the exercise price of the option. The strike is the decided price of the underlying asset to which it converts at maturity. For example, an exercise price of $ 25 for a GE call option would mean that an investor could buy 100 GE shares at $ 25 at maturity. The investor will exercise the option of $ 25 if the market price is higher than the exercise price. If it is lower, the investor will allow the option to expire and lose the price paid for the premium. Also remember that each option contract, put or call, is equivalent to 100 shares of the underlying asset.
An investor should understand that he will tie funds to these long-term contracts. Variations in the market interest rate and in the volatility of the market or of assets can make these options more or less valuable depending on the ownership and the direction of movement.
Key points to remember
- Long-term equity anticipation securities are ideal for option traders who wish to trade a prolonged trend.
- LEAPS can be applied to a particular stock or to an index as a whole.
- LEAPS are often used in hedging strategies and can be particularly effective in protecting retirement portfolios.
Premiums are a non-refundable cost for trading in the options market. The premiums for LEAPS are higher than those for standard options in the same stock. The longer expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. Known as time value option markets, use this long delay and the intrinsic value of the contract to determine the value of the option.
The intrinsic value is the calculated or estimated value of the probability that the option will be to make a profit according to the difference between the market of the asset and the exercise price. This value can include the profit that already exists in the contract before the purchase. The contract maker will use a fundamental analysis of the underlying asset or business to help place intrinsic value.
As mentioned earlier, the option contract has a base of 100 shares of assets. So if the premium for Facebook (FB) is $ 6.25, the option buyer will pay a total premium of $ 625 ($ 6.25 x 100 = $ 625).
Other factors that can affect the price of the premium include stock volatility, market interest rate and whether the asset pays dividends. Finally, throughout the duration of the contract, the option will have a theoretical value derived from the use of different pricing models. This fluctuating price indicates what the holder can receive if he sells his contract to another investor before expiration.
LEAPS vs short-term contracts
LEAPS also allows investors to access the long-term options market without the need to use a combination of shorter-term option contracts. Short-term options have a maximum expiration date of one year. Without LEAPS, investors who wanted a two-year option would have to buy a one-year option, let it expire, and buy a new one-year option contract simultaneously.
The process, called contract renewals, would expose the investor to market movements in the prices of the underlying asset as well as additional option premiums. LEAPS offers the longer-term trader exposure to a prolonged trend, in particular security with a single trade.
Stocks – another name for stocks – LEAPS call options allow investors to take advantage of potential increases in a specific stock while using less capital than buying stocks in cash initially. In other words, the cost of the premium for an option is less than the cash required to buy 100 shares outright. Like short-term call options, LEAPS calls allow investors to exercise their options by buying the shares of the underlying stock at the exercise price.
Another advantage of LEAPS calls is that they allow the holder to sell the contract at any time before expiration. The difference in premiums between the purchase and sale prices can lead to a profit or a loss. In addition, investors must include any fees or commissions charged by their broker to buy or sell the contract.
LEAPS provides investors with long-term cover if they hold the underlying shares. Put options increase in value as the price of an underlying stock decreases, potentially offsetting the losses incurred from owning the stock. Essentially, the put can help cushion the blow from falling asset prices.
For example, an investor who owns shares of XYZ Inc. and wants to hold them for the long term may be concerned that the stock price may fall. The investor could buy LEAPS puts XYZ to hedge against adverse movements in the long position in equities. LEAPS allows investors to benefit from lower prices without having to short sell underlying stocks.
Short selling involves borrowing stocks from a broker and selling them in the hope that the stock will continue to depreciate at maturity. At maturity, stocks are bought – hopefully at a lower price – and the position is offset for a gain or loss. However, short selling can be extremely risky if stock prices go up rather than go down, causing significant losses.
As a review, a market index is a notional portfolio made up of several underlying assets that represent a market segment, an industry or other groups of securities. There are LEAPS available for stock indexes. Like LEAPS for individual stocks, index LEAPS allow investors to hedge and invest in indices such as the Standard & Poor’s 500 Index (S&P 500).
LEAPS Index gives the holder the possibility to follow the entire stock market or specific industrial sectors. Index LEAPS allow investors to take a bullish position using put options or a bearish position using put options. Investors could also hedge their portfolios against adverse market movements with the LEAPS indices.
A long delay allows the sale of the option
Used to hedge a long-term investment or portfolio
Available for stock market indices
More expensive premiums
Long period of time binds investments
Market or business movements can be unfavorable
Real LEAPS example
Let’s say an investor has a portfolio of securities, which mainly includes the components of the S&P 500. The investor thinks there could be a market correction in the next two years. As a result, they buy the LEAPS index puts on the S&P 500 index to protect themselves against adverse movements.
An investor buys a LEAPS put option in December 2021 with an exercise price of 3,000 for the S&P 500 and pays $ 300 in advance for the right to sell the index shares at 3,000 on the expiration date of the option.
If the index falls below 3000 at maturity, the equity holdings in the portfolio will likely drop, but the LEAPS put will increase in value, helping to offset the loss in the portfolio. However, if the S&P increases, the LEAPS put option will expire worthless and the investor will be deprived of the $ 300 premium.