What it means
An option is a contract that gives the holder the right, but not the obligation, to buy (a call) or sell (a put) a share at a fixed price, called the strike price, before a set expiry date. A standard option may expire in days or months, but a LEAPS option can run for over a year.
The longer life means the holder does not have to be right about timing in the short term. Because there is more time for the share to move, LEAPS cost more than short-dated options, with the price made up of intrinsic value and time value.
Intrinsic value is how far the option is already in the money, and time value is the extra paid for the chance of further movement. Time value decays as expiry draws closer, but more slowly for LEAPS than for short options.
Investors use LEAPS in two main ways. A LEAPS call can act as a lower-cost stand-in for owning the shares, giving exposure to gains while tying up less cash.
A LEAPS put can act as long-term insurance on a portfolio, setting a floor on losses until expiry. The costs and risks need to be understood.
The whole premium paid can be lost if the share does not rise above the strike price plus the premium by expiry, and the break-even price is therefore well above the current price. Options also do not pay dividends, so the holder forgoes any income that the shares would have produced.
For a finance professional, LEAPS appear in executive compensation analysis, hedging programmes and treasury discussions about protecting a large holding. They are standardised, exchange-traded contracts, with each contract normally covering 100 shares.
Tax treatment and accounting rules differ by country, so those aspects should be checked locally.
In practice
Real-world examples.
Example
An investor believes a pharmaceutical company's new drug will succeed over the next two years. She buys LEAPS calls instead of shares, spending $3,000 rather than $15,000. If the drug fails, her loss is limited to the $3,000.
Example
A founder holding a large block of shares in a listed company buys LEAPS puts to protect against a fall in the share price. The premium is treated as the cost of insurance. If the price drops sharply, the puts rise in value and offset the loss on the shares.
Example
A fund manager sells LEAPS puts at a strike price below the market, collecting premium upfront. The manager is willing to buy the shares at that lower price if the option is exercised. The finance team monitors the obligation as a contingent liability on the fund.
Formula
Calculation
Call option break-even = strike price + premium paid. Profit at expiry = (share price - strike price) - premium, if the share price is above the strike
A share trades at $100. An investor buys a two-year LEAPS call with a strike price of $90, paying a premium of $20 per share, so a contract covering 100 shares costs $2,000. The break-even is $90 + $20 = $110. If the share rises to $130 by expiry, the call is worth $130 - $90 = $40 per share, a profit of $40 - $20 = $20 per share, or $2,000 per contract, which is a 100% return on the $2,000 paid. Buying the shares outright would have returned $30 on $100, or 30%, but required $10,000 for 100 shares.Case study
Seen in the real world.
Larkspur Capital is an illustrative, fictional investment club that wanted exposure to a technology company trading at $200 a share but could not afford a large position. Instead of buying 100 shares for $20,000, it bought one LEAPS call contract with a strike price of $180, two years to expiry, for a premium of $38 per share, or $3,800.
After 18 months the share traded at $260. The call was worth about $80 per share, or $8,000 per contract, a gain of $4,200 on a $3,800 outlay, which is a return of roughly 110%. Buying shares would have returned $60 on $200, or 30%. The illustrative lesson is that LEAPS can magnify gains, but had the share stayed flat the club would have lost most of its $3,800.
Watch out
Common mistakes.
- Thinking LEAPS are risk free because they last a long time, when the entire premium can be lost if the share does not move far enough.
- Ignoring the break-even price, which includes the premium and sits above the strike price for a call.
- Forgetting that options carry no dividends or voting rights, unlike the shares themselves.
Questions
People also ask.
How long is a LEAPS option?
It has an expiry of more than one year, and listed contracts commonly run up to about two or three years.
What is the difference between LEAPS and normal options?
They have the same rights, but LEAPS last longer and therefore cost more and lose time value more slowly.
Can LEAPS be used for hedging?
Yes. A LEAPS put on a share or index can protect a long-term holding against a fall in price for the length of the contract.
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