Here's Why LEAPS is a Good Instrument for New Investors in Options

LEAPS: A Good Instrument for New Investors in Options
Investing in options is best left to more seasoned investors, but for those making the jump into this field, LEAPS can be a very good choice.
WealthHow Staff
Last Updated: May 31, 2018
Many newer and inexperienced investors hear the siren call of equity options, ignoring the advice of a financial advisor, and get into buying and selling calls and puts without the requisite knowledge to trade in them. While it is true that these can be risky investments, as long as the investor understands the risk and reward associated, trading in them is relatively safe. Trading without a clear understanding, however, is a potential recipe for disaster.

For those who understand but are relatively new to investing and hesitant to trade in options, there are instruments that offer a better choice. LEAPS, which stand for 'Long-term Equity AnticiPation Securities,' are merely options that have expiration dates much further in the future. As such, novice investors can generally avoid the risk associated with very short-term expiration dates and utilize them to gain leverage without undue risk.

They were created relatively recently and typically extend for terms of 2 years out. Equity LEAPS have expiration dates in January, the result of which is a long, two-year window in which the underlying equity can move in the anticipated direction and make profits. As with any investment, of course, the price of the underlying stock can easily go in the opposite direction of the anticipated movement. For the savvy trader, however, they offer a limited-risk, big-reward play that, if utilized properly, can be highly effective. To illustrate this, we'll examine a hypothetical scenario.

Example

Let's say that you're interested in the stock of XYZ Corp., which is trading at USD 10 per share. You've done the research and expect that the price of the stock could go up to USD 20 within the next two years. So, if you wanted to make a trade based on this assumption, you would buy 1,000 shares of the stock for USD 10,000. Let's say, for instance, that the price then goes to USD 20 after two years. Closing the position (selling all the shares) would result in a gain of USD 10,000 i.e. a gain of 100% in just 2 years!

However, let's consider an alternative. Under LEAPS, the buyer of a call trade would hold 100 shares of the underlying stock, for every lot purchased. If we assume that the USD 15 LEAPS call option for XYZ Corp., that expires in two years, is priced at USD 2 per share, it means that each lot will cost USD 200 (USD 2 x 100 shares). Therefore, an investment of USD 10,000 would allow you to hold 5,000 shares of XYZ Corp. (50 contracts of USD 200 each x 100 shares)

Now, let's assume the same price jump, as in our initial investment scenario: USD 20 per share at the end of the two-year period. You will be able to exercise the shares at USD 20 so that your gain is the difference between the gross value of shares (5,000 x USD 20, or USD 100,000) and the total of exercise price plus option premium (5,000 x USD 17, or USD 85,000). We arrive at USD 17 by adding the strike price of USD 15 to the option premium of USD 2. The net gain on the trade turns out to be USD 15,000 (150%), which is higher than the USD 10,000 gained by buying the underlying shares.

The above example is a good indication of what LEAPS can do, if utilized properly.

Disclaimer: This article is for reference purposes only and does not directly recommend any specific investment choices.