If you’re familiar with stock trading but are new to options, LEAPS (long-term equity anticipation securities) can be an excellent entry point. LEAPS options have a longer time horizon than traditional option contracts and are typically less volatile than other options (but are comparable in volatility to the underlying stock).
There are a handful of reasons that you may want to trade LEAPS options instead of the underlying security, most notably because you can leverage your investment by controlling more shares at a lower cost. To help you better understand LEAPS investing, here are three benefits of entering the world of LEAPS.
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LEAPS Options Pro #1 – Leveraged Equity Exposure
This feature is the primary reason that many investors find LEAPS options attractive. Buying at- or near-the-money calls is far less expensive than buying the underlying security but offers you exposure to the upside (in the case of calls) of a stock you’re bullish on. Buying a LEAPS contract allows you to invest in the equivalent of 100 shares of the underlying stock at a fraction of the price.
When the stock trades above your contract strike price, your LEAPS options will gain intrinsic value (and lose time and volatility premium) which can lead to big gains. This leveraged exposure means that a stock that trades 10% or 20% higher in a bull market could translate to gains of 100% or more in the LEAPS. Stocks showing positive momentum are some of the best stocks to trade LEAPS on. If you’re looking at turnaround stocks and are hoping for a reversal, the time-limited nature of LEAPS can work against you.
LEAPS Options Pro #2 – Limited Downside Risk
The worst-case scenario when buying any stock is that the shares trade to zero and you lose your entire investment. That’s an incredibly unlikely scenario and it’s far more likely that the declining share price would prompt you to sell once your stop-loss is triggered. That scenario also holds true for LEAPS options.
However, with LEAP options, because your initial capital outlay is smaller, you’re naturally limiting the downside risk. A near-the-money contract in Tesla (TSLA), for instance, expiring in just over a year, costs roughly 25% of the current share price. If you were to use LEAPS to invest in the stock, you’d gain upside exposure to 100 shares with a maximum loss of only 25% of the share price.
LEAPS Options Pro #3 – Better Volatility Mitigation
An option contract carries two kinds of value, intrinsic value and time-and-volatility premium. If your contract is “in the money” (meaning that the contract strike price is below the current share price) its intrinsic value is the difference between the strike price and share price.
For example, if you have a contract for XYZ Company with a strike price of 20 and the shares are trading at 22, you have $2 per share of intrinsic value ($200 per contract). Contracts that are “out of the money” or “near the money” (meaning the contract price is near or above the stock’s share price) are valued entirely on time-and-volatility premium.
These premium valuations are highly dependent on the underlying stock, and a stock that has previously had wild price swings or a rapid increase in value will typically command higher premiums, as will stocks that have upcoming earnings reports or other catalysts.
The longer-term nature of LEAPS options can help mute the short-term market noise that can cause price spikes in shorter-term option contracts.
Initially, as the price of the underlying security rises, you’ll find that LEAPS contracts don’t gain as much value as the new intrinsic value replaces the time-and-volatility premium. Ideally, the share price will continue to rise to the point that your LEAPS contract is priced almost entirely by intrinsic value.
At that point, the contract will begin to trade as a stock analog where you’ll see dollar-for-dollar gains in the underlying contract. If you’ve reached that stage with your LEAPS investing, you’ll be taking full advantage of the aforementioned leveraged equity exposure because your investment for a fraction of the price of the shares will enjoy 100% of further gains.
If you’re interested in learning more about LEAPS options and options in general, you can read more in this free report.
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*This post is periodically updated to reflect market conditions.
