LEAPS = Leverage

This article will explain the concept of LEAPS (Long-term Equity AnticiPation Securities) which is often puzzling to novice option traders.

An appropriate way to commence our scrutiny is simply by going to the CBOE (Chicago Board of Option Exchange) website and using their facts; after all, it was the CBOE who first listed LEAPS back in 1990. According to their webpage, LEAPS are long-term options contracts that can be maintained up to three years. However, it is also possible to define LEAPS as anything that is expiring more than seven months out. The website states that LEAPS are suitable for conservative investors because they have many similarities to actually holding the shares of stock. It is this precise point that we will be examining in greater depth in the next few paragraphs.

Moving on, in terms of the contract specifications, LEAPS have everything that regular stock options have in terms of strike prices and the Greeks; it is only that the expiration is further out than the average monthly option. However, not all the strike prices are listed on LEAPS right away. Figure 1 illustrates that point.

The option chain above shows that on the front month of AAPL, the strike price increments are 5 points wide while on the LEAPS for Jan 2014, strikes are 10 points wide. More strike prices will get added as the time to expiration decreases.

Now, let us turn our attention to our core question: Why would anyone want to buy LEAPS when they could simply buy the underlying shares? First, because buying LEAPS is more economical than an outright underlying purchase. Second, LEAPS are a leveraged product and third, LEAPS give an ample amount of the time for the underlying to actually move making an option profitable.

The CBOE website also points out that a LEAPS put could provide a hedge against substantial declines in underlying equities. This means that the investors who own, for example, 100 shares of the underlying stock could buy a single LEAPS put to protect their investment; let us call this strategy Choice A. There are variations of that strategy, depending on what is owned. Once again, Choice A - if we own stocks, then we could protect the stock shares with the corresponding number of put LEAPS. Choice B - if we own only call LEAPS, then buying a shorter term put at the level (strike price) where the stop would be is a correct way of hedging the position.
Lastly, Choice C - buying a call LEAPS and instantly placing another put LEAPS on it would be the most economical thing to do.

Nevertheless, one thing that the CBOE website does not address is what strikes to select, which are logical. So, let us turn our attention to which strike price should be selected? To be honest, that isn't the right question to ask. The focus should not be on the actual strike price selection but on selecting the correct Delta, or Intrinsic Value. The strike prices simply turn out to be a byproduct of the Delta/Intrinsic Value selection. An easy answer to this question is the higher the Delta, the better. The higher the intrinsic value, the higher Delta value is. Even when selecting deep in-the-money Deltas, which translate to higher intrinsic value, LEAPS ownership costs less than a straight purchase of the shares of the underlying.

For instance, let us compare the outright purchase of AAPL with buying two different types of LEAPS: Figure 1 shows that AAPL closed at $373.20 on Tuesday 11/29/11, and the cost of 100 shares would be exactly $37,320. Next, let us compare that cost with buying a single contract of January 2013 LEAPS with a Strike price of 350. Figure 2 shows the options chain for the AAPL LEAPS.

Learn to Trade Now