This article will delve into the world of LEAPS (Long-Term Equity Anticipation Securities) options, explaining their benefits, drawbacks, and how they can be used as an alternative to owning 100 shares of a stock. We will examine the components of option premiums and compare the risk profiles of LEAPS and stock ownership.
What are LEAPS?
LEAPS are long-term equity anticipation securities, essentially long-dated options. The "anticipation" refers to the long expiration date. A LEAPS call option is similar to owning 100 shares of the underlying stock. They are typically deep in the money and have expirations far into the future, usually nine months or more.
LEAPS Calls and Delta
A LEAPS call that is deep in the money will have a delta close to one. This means that for every dollar the underlying stock rises, the LEAPS option will increase in value by approximately $1 per share (or $100 for the contract representing 100 shares). Owning 100 shares also yields a delta of one per share.
Benefits of Using LEAPS
The primary advantage of using LEAPS is the reduced buying power required compared to purchasing 100 shares. You can achieve similar exposure to the stock's price movement with a fraction of the capital. This allows for leverage.
Drawbacks and Risks of LEAPS
While LEAPS offer significant benefits, there are also drawbacks to consider. The main concern is the extrinsic value of the option, which can be lost if held to expiration.
Extrinsic Value vs. Intrinsic Value
An option's premium consists of two parts:
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Intrinsic Value: The value derived from the immediate profit that could be realized by exercising the option. It is the difference between the current stock price and the strike price for in-the-money options.
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Extrinsic Value: The value derived from the time remaining until expiration and the implied volatility of the underlying asset. This represents the potential for the option to move further into the money. Extrinsic value decays over time, especially closer to the expiration date.
Risk Comparison: LEAPS vs. Stock Ownership
The main difference in risk between LEAPS and owning 100 shares lies in the extrinsic value. With LEAPS, you risk losing the extrinsic value if the option expires out of the money or is held to expiration. However, if held long-term and managed correctly you might get a decent profit.
Downside Protection
LEAPS offer a degree of downside protection. If the stock price falls below the strike price at expiration, the LEAPS call option becomes worthless, and the maximum loss is limited to the premium paid. Conversely, owning 100 shares exposes you to unlimited downside risk until the share price hits zero.
Liquidity Considerations
Liquidity can be a concern with LEAPS, especially for options that are deep in the money or far out of the money. However, even with limited liquidity, you always have the option to exercise the contract and buy the shares at the strike price.
Strategies for Using LEAPS
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Recouping Extrinsic Value: The reduced buying power with LEAPS allows you to invest the freed-up capital elsewhere, potentially generating a return that compensates for the potential loss of extrinsic value.
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Long-Term Investment Approach: LEAPS can be a suitable option for long-term investors who want leveraged exposure to a stock without tying up a large amount of capital.
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Avoiding Short-Term, Out-of-the-Money Options: LEAPS offer a contrasting approach to high-risk, short-term options strategies, as they provide a lower breakeven point and more time for the investment to become profitable.
Conclusion
LEAPS can be a valuable tool for investors seeking leveraged exposure to stocks with a defined risk profile. By understanding the components of option premiums and carefully considering the potential loss of extrinsic value, investors can utilize LEAPS to achieve their financial goals. While owning shares directly is simpler, LEAPS offer distinct advantages, particularly for long-term investors with a solid understanding of options.
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