LEAPS Options: Basics, Strategies, Risks
One major challenge of trading options is getting the timing right. Even when a trader correctly predicts where a stock is headed, the move may not happen before their option expires.
LEAPS give traders more time for their investment thesis to play out and can be used in strategies ranging from straightforward hedges to more complex trades like bull call spreads. However, traders should understand how LEAPS' longer periods until expiration can influence their pricing and their sensitivity to changes in implied volatility (IV), interest rates, and time decay before placing a trade.
What are LEAPS?
Long-Term Equity Anticipation Securities (LEAPS) are long-dated options contracts that have more than one year until expiration when they are listed. Like shorter-term options, they give buyers the right—but not the obligation—to buy or sell an underlying security at a set strike price by a specific date. The only difference between LEAPS and standard options is the longer time to expiration, which changes how LEAPS are used and priced.
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Common uses of LEAPS
LEAPS' longer time until expiration can make them useful for a range of trading strategies. Many traders buy LEAPS calls as an alternative to direct stock ownership, while others use LEAPS puts to hedge their portfolios against market downturns. LEAPS can also serve as building blocks for more complex trades, including calendar spreads, call spreads, and a type of synthetic covered call famously known as a poor man's covered call.
Hedging
Hedging against broad market downturns or risk in a specific stock is one of the most common uses of LEAPS. When investors want to maintain their market exposure while adding a longer-term hedge, they often turn to LEAPS puts.
For example, imagine an investor holds a majority of their portfolio in an exchange-traded fund (ETF) that tracks a broad market index like the S&P 500® Index (SPX). They expect stocks to rise over the long term but fear a market correction may be coming within the next year, so they purchase a LEAPS put on the ETF as a hedge.
If the ETF falls, the LEAPS put would typically increase in value, helping offset some of the investor's losses. If the ETF rises instead, the investor can still participate in the rally through their existing portfolio, although the cost of the put would reduce their overall return.
Stock alternative
Traders also use LEAPS calls as an alternative to buying stocks outright because they can provide exposure to stocks with lower upfront capital requirement. This can free up capital for other uses or investments while still allowing traders to potentially profit if the stock rises.
However, owning a LEAPS call isn't the same as owning the underlying stock. Options eventually expire, they lose value from time decay, and they don't provide benefits like dividends or voting rights. LEAPS call buyers can also lose their entire premium if the stock doesn't move enough in their favor before expiration.
LEAPS example
Let's walk through an example that shows why some traders might use a LEAPS call as an alternative to buying a stock directly.
Suppose a trader is bullish on ZYX stock. With ZYX shares trading at $100, buying 100 shares would cost $10,000. That's a lot of capital to tie up in a single investment, so the trader decides to look at LEAPS call options to see if they're more practical.
They opt for an 80-strike call option expiring in 18 months with a $30 premium. Buying one call contract would cost roughly $3,000 ($30 x 100-share-contract multiplier).
Let's consider three scenarios for how the two positions could perform after 18 months, assuming the LEAPS call is held until expiration. Note: These examples do not include the impact of commissions, taxes, or fees.
Scenario 1: ZYX falls from $100 to $80.
- Stock: The 100 shares are now worth $8,000, leaving the trader with a $2,000 loss.
- LEAPS call: The call expires worthless. The trader loses the entire $3,000 premium paid to open the trade.
Scenario 2: ZYX remains at $100.
- Stock: The 100 shares are still worth $10,000, so the trader breaks even.
- LEAPS call: The call is $20 ITM ($100 – 80 strike), giving it a value of $2,000 ($20 x 100). The trader loses $1,000 after subtracting the $3,000 premium paid.
Scenario 3: ZYX rises from $100 to $120.
- Stock: The 100 shares are now worth $12,000, leaving the trader with a $2,000 (or 20%) gain.
- LEAPS call: The call is $40 ITM ($120 – 80 strike), making it worth $4,000 ($40 x 100). The trader profits $1,000 (or 33%) after subtracting the $3,000 premium paid.
Here's a quick look at the potential profit or loss for each scenario, along with two additional scenarios showing the impact of more extreme stock price swings.
This example highlights the trade-offs of using LEAPS as a stock alternative. While LEAPS require less initial capital and can magnify percentage gains at times, they can also magnify losses up to certain price levels since they expire worthless if the stock doesn't perform as expected.
The example also doesn't account for how the trader might have spent or invested the $7,000 in initial capital that would have been saved by buying the LEAPS call versus buying the stock outright. The opportunity cost of buying a stock instead of a LEAPS call often makes a big difference when a trader is deciding which strategy to use.
Pros and cons of LEAPS
LEAPS can be used effectively in a variety of trading strategies, but they also come with trade-offs. They typically have higher premiums than otherwise comparable shorter-term options and are still exposed to risks like time decay as well as changes in IV and interest rates.
As a result, a trader can still lose money on a LEAPS trade even after correctly predicting the direction of an underlying stock move. For example, let's say a trader buys a LEAPS call option, and the stock rises as expected. If IV also falls significantly after the purchase, the call option could gain less value than expected or even lose value. This is because a decline in IV reduces the call option's extrinsic value.
Time decay also eats away at the value of LEAPS, as it does with shorter-term options. While this value erosion is generally less pronounced early on, it can accelerate as expiration approaches. Here's a quick look at some potential pros and cons of LEAPS options.
Bottom line: Flexibility for traders and investors
LEAPS can offer flexibility for both active traders and long-term investors, but the two groups typically use them in different ways. Active traders sometimes use LEAPS to improve capital efficiency while seeking to generate income or speculate on stock price movements. Long-term investors, meanwhile, typically use LEAPS as stock alternatives or hedges. Either way, these options come with trade-offs, and it's critical to understand the mechanics involved before placing a trade.
LEAPS FAQs
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The securities, investment products and investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment or trading decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
For illustrative purposes only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve.
Investing involves risk, including loss of principal, and for some products and strategies, loss of more than your initial investment.
Past performance is no guarantee of future results.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call Schwab at 1-800-435-4000 for a current copy. Supporting documentation for any claims or statistical information is available upon request.
With long options, investors may lose 100% of funds invested.
Multiple leg options strategies will involve multiple transaction costs.
Uncovered options strategies are only appropriate for traders with the highest risk tolerance, may involve potential for unlimited risk, and are only allowed in margin accounts.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Spread trading must be done in a margin account.