Explainers

Leaping with LEAPS

April 21, 2021

Leaping with LEAPS

Most of the options have a maturity of 1 month, 2 months or 3 months. But what does a trader do if he/she has a long-term view on the underlying? Enter LEAPS.

LEAPS (Long-Term Equity AnticiPation Securities) are options with a higher time period, typically more than a year and up to three years. LEAPS came about in 1990 and were sold as derivative instruments to extend options for up to two years.

So, How Does One Go About It?

The usual way to buy a LEAPS call is to look for a deep ITM call for a given underlying that is deemed to perform well in the future. The deeper ITM options will be priced higher, but a high delta gives the advantage of being a substitute for stock. The time frame has to be selected such that the option value goes down exponentially as maturity arrives.

This strategy is more of an investment, rather than pure speculation.

Let’s say a person wants to purchase several shares of Company XYZ. It’s trading at Rs. 20 and she has Rs. 20,000 to invest. She believes that XYZ is bound to grow within a year or two and wants to remain invested in the stock. Now, she has three options.

Option 1 – She purchases the stock outrightly

She gets to buy 1000 stocks (at Rs. 20 each) for Rs. 20,000. She would lose the entire amount in case the stock crashes.

Option 2 – She purchases the stock on margin

She can pledge shares and leverage in the ratio 2:1. In this case, her investment goes up to 40,000 (2000 stocks) but she also has an offsetting debt of 20,000. If the pledged stock crashes or she gets a margin call, then she would be forced to sell at a loss. She would also have to pay the interest for the privilege of borrowing that extra money on margin.

Option 3 – She purchases LEAPS

Firstly, buying LEAPS reduces direct exposure to the stock market volatility. Let’s say the strike price is Rs. 25, the time period is 2 years and the premium is Rs. 1.5 per share. She buys 100 contracts and is exposed to 10,000 shares (Rs. 15,000 premium). If the stock price lands below Rs. 25, the only thing lost is the premium. The stock price needs to cross Rs. 26.5 for her to break even.

Advantages of LEAPS

  • The longer time frame translates to a bigger window for profitability, as the underlying can go up more.
  • Time value in the case of LEAPS options erodes more slowly vis-à-vis traditional options.

Drawbacks of LEAPS

  • Options are priced higher than their short-term counterparts for similar strikes. This means that the buyer would have to pay a higher premium upfront.
  • LEAPs aren’t available for every optionable stock.

LEAPS are suitable for experienced players who can employ strategic trading and make the most of it in the long run. The most important factor is that the trader must be able to afford the upfront capital to be invested along with the understanding that the value can tank down to zero.

Disclaimer – Investment in securities market are subject to market risks, read all the related documents carefully before investing.This content is purely for information and investor awareness purpose only and in no way an advice or recommendation. You should independently research and verify the information you find on our website/application.

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