Long-term Equity Anticipation Securities (LEAPS) are options contracts with longer expiration dates than standard options, which usually expire in a year or less. The expiration dates for LEAPS are usually over a year, but some can have up to three-year expiration dates.
Investors can use LEAPS instead of buying an underlying stock outright. This strategy gives investors control of a set number of shares (usually 100 per contract) with fewer capital requirements.
The downside risk of this strategy is having the options contracts expire worthless. However, this risk is managed as the time horizon for LEAPS is longer than standard options contracts.
An options contract gives the holder the right to buy (calls) or sell (puts) a set number of shares of a stock at a predetermined price. For the strategy described, only call options will be discussed. Puts are often used for hedging. Also, no commissions are considered in this example.
An option chain contains several contracts, which represent the “moneyness” of the option. The moneyness helps determine the price of the premium and its probability of being profitable on the expiration date.
The three types of moneyness are in-the-money, out-of-the-money, and at-the-money. A contract is at-the-money when its stock price is close to the strike price.
Contracts that are in-the-money means the stock price is higher than the strike price. Out-of-the-money options occur when the stock price is lower than the strike price.
Discounting stocks using LEAPS
The long-term aspect of LEAPS is what helps make this strategy work. Suppose an investor was looking to purchase shares of Microsoft (MSFT). At the time of this writing those shares would cost the investor approximately $210 per share. For 100 shares, this would represent a $21,000 investment.
As Microsoft is a solid company, the investor may feel confident that investing 100 shares in the company is worthwhile.
However, $21,000 is more than many people are comfortable spending on any one stock. Here is how a LEAPS strategy can be implemented for significantly fewer dollars.
An investor would search for an options contract with an expiration date at least one year away. To keep the concept simple, the investor can limit contracts to only at-the-money options.
As the investor gains experience with the strategy, he can choose other contracts that are not at-the-money. However, sticking with the at-the-money strategy keeps the strategy manageable at first.
The investor should always choose a contract with at least one year (preferably more) before expiration. The further the duration, the higher the cost of the premium for the contract.
However, the prices of stocks like Microsoft have a higher chance of increasing in two years rather than one. Therefore, the added time may be worth the extra cost in premium. The objective of this strategy is to use the LEAP as a substitute for the stock, not to find the best option that can maximize gains in the short term.
Suppose the investor decided to choose an at-the-money option contract expiring in January 2022. This represents an expiration date of approximately one year and five months at the time of this writing.
A glance at the last price for the at-the-money contract is $33.77. If the investor obtained a price of $34 for the contract, the outlay for this investment would be $3,400. That is much less than the $21,000 required to purchase the stock outright.
Even if the market moves quickly and the investor obtains a price of $36 for the contract, $3,600 is still a great discount to the underlying stock.
Investors have several options after purchasing a contract, from holding the contract to expiration, exercising the contract early, or closing out the contract.
However, the objective is to use LEAPS to purchase the stock at a discount. If investors bought the stock outright with the intent of holding onto it, the same strategy should probably be used when using LEAPS as a substitute for the stock.