What it means
A normal call option gives the holder the right to buy a share at a fixed price on or before a future date. The strike is typically near the current market price, so the option is cheap relative to the share and is mostly a bet on movement.
A LEPO flips that logic by choosing a strike price close to zero. With a strike of almost nothing, the option will certainly be exercised at expiry, so its value is nearly the same as the share's value.
The holder gets the share price gains and losses almost one for one. The main differences are that the holder does not receive the dividends paid during the option's life, and that the option usually expires on a fixed date.
LEPOs developed in markets such as Australia's, where they offered an exchange-traded way to take a position in a share when buying, borrowing or short selling the underlying share could be restricted or costly. A trader could therefore gain exposure to, or hedge against, a share without handling the share itself.
The price of a LEPO is easy to estimate. It is roughly the share price, less the present value of the small strike, less the present value of any dividends the share will pay before expiry.
Because the option does not collect dividends, its price drops by the dividend amount when the share goes ex-dividend, just as the share price itself does. For a non-specialist, the point is that LEPOs show how options can be built to replicate a different position.
They also carry counterparty and liquidity risks, so a buyer needs to know who guarantees the contract and how easily it can be sold.
In practice
Real-world examples.
Example
A fund manager in Sydney wants to gain exposure to a mining company without buying the shares directly. She buys LEPOs on the company with a strike of one cent. The position rises and falls with the share price, and she avoids some of the costs of holding shares.
Example
A trader at a securities firm needs to hedge a client position in a bank share ahead of an earnings announcement. He sells LEPOs in the same share to offset the risk. If the share falls, the gain on the LEPOs compensates for the loss on the client's holding.
Example
A private investor believes a retail share will rise over the next three months. She buys LEPOs expiring in three months, which cost slightly less than the share because the dividend is not included. When the share rises, her profit is nearly the same as a shareholder's.
Formula
Calculation
LEPO value is approximately: Share price - Strike price - Expected dividends before expiry (all in present value terms)
Worked example: a share trades at $40.00. A LEPO has a strike of $0.01 and expires in six months. The share is expected to pay a dividend of $1.00 before expiry. To keep the arithmetic simple, ignore discounting.
LEPO value is about $40.00 - $0.01 - $1.00 = $38.99.
An investor buys 1,000 LEPOs for 1,000 x $38.99 = $38,990. If the share rises to $44.00 at expiry, the LEPO settles for $44.00 - $0.01 = $43.99, giving a payout of $43,990. The profit is $43,990 - $38,990 = $5,000, or about 12.8% on the outlay of $38,990, while the share price rose 10%, from $40 to $44. The investor misses the $1,000 of dividends that a shareholder would have received.Case study
Seen in the real world.
Redstone Securities is a fictional brokerage whose institutional client wanted to take a short-term position in a share that was difficult to borrow and sell short. The desk proposed a combination of LEPOs and futures to build the exposure at manageable cost.
The client bought LEPOs on 20,000 shares priced at $25.00, paying $499,800 in total, or $24.99 each, and no dividend was due before expiry. The share fell to $22.50, so each option settled at $22.49 and lost $2.50, a total loss of $50,000, which matched the share price move exactly.
The client had expected the hedge to behave like the share and it did, but the finance team had not allowed for the fact that the broker required collateral against the position. This is an illustrative story, but it shows how a LEPO tracks the underlying share closely while carrying its own operational requirements.
Watch out
Common mistakes.
- Treating a LEPO as the same as owning the share. It is very similar in price movement, but the holder usually does not receive dividends or voting rights.
- Assuming a low strike means low risk. A LEPO can lose nearly all of its value if the share price collapses, just like the share itself.
- Ignoring the counterparty and liquidity risks. If the issuer of the option fails, or no buyer is available, the holder may have difficulty exiting.
Questions
People also ask.
What does LEPO stand for?
Low exercise price option. The name describes the main feature, a strike price close to zero.
Why would anyone use a LEPO rather than the share?
Typical reasons are to avoid certain transaction costs, to gain exposure where direct trading is restricted, or to take a position that settles in cash. The right choice depends on local rules and costs.
Do LEPOs pay dividends?
Generally not. The price of the option reflects the loss of dividends before expiry, so the holder is compensated by a lower purchase price.
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