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LEAPS Options

What are LEAPs options, what does it stand for and what are its characteristics?

LEAPS options - Definition

Long term options with expiration of up to 39 months and expires every January of the year.

LEAPS options - Introduction

LEAPS options is short form for Long Term Equity Anticipation Securities options (As such, it is LEAPS options and not LEAP options like so many people tend to misspell). As the name suggests, LEAPS Options are options with extremely long expiration dates. Yes, while standard options only have up to 9 months to expiration, LEAPS options have expiration that goes all the way out to 3 years. Trading of LEAPS options allows long term speculation as well as long term hedging to be performed and is also one of the most important innovations in options trading. This tutorial shall explore what LEAPS options are, its history as well as specification.

What are LEAPS options?

LEAPS Options were started in 1990 for the sake of long term leveraged speculation. One of the main drawbacks of buying options before LEAPS options were created was that standardized options, with only a few months to expiration, has too short a life for long term options trading purpose. With the creation of LEAPS options, long term investors could now buy LEAPS instead of the stock itself for more leverage as LEAPS options have expiration of as long as 3 years. Indeed, long term investing was a void in options trading before the creation of LEAPS options.

Even though LEAPS options are special options with unique specifications, they are so well blended into options chains that you can hardly tell which are the LEAPS options. In fact, it isn't important for options traders and investors to know if an option is known as LEAPS options or not as long as the expiration fulfills investment or options trading requirements.

There is a growing misunderstanding amongst the options trading community that all options with long expirations of more than 9 months are known as LEAPS options. In fact, the term "LEAPS" is becoming the term options traders use to refer to options with long expiration, whether or not those options are actually LEAPS options. Nowadays, very long expiration is not offered only by LEAPS options as there are other kinds of options such as the "Quarterlies" with expiration date of more than a year out. Options traders should take note of this in future discussions.

OppiE's NoteSome options traders or options websites refer to LEAPS incorrectly as "LEAPs", as a plural form, or simply LEAP. The "S" in LEAPS stands for "Securities", not a singular or plural function. In fact, the term "LEAPS®" is a reserved trademark on its own and should not be incorrectly quoted.

Types of LEAPS Options

There are two main types of LEAPS options; Equity LEAPS Options and Index LEAPS Options.

Equity LEAPS Options are LEAPS Options for individual stocks while Index LEAPS Options are LEAPS Options based on index such as the Volatility Index (VXN) or the Dow Jones Industrial Average (DJX). Like standardized short term stock options, LEAPS options come with both call options and put options as well.

What are LEAPS Options Used For?

Even though the longer the time to expiration an option has, the more advantageous it is, most short term options traders do not need such long expirations and would not want to pay the price for it. So, what are LEAPS options used for?

Replacement for Stock Ownership
Instead of committing a significant capital committment to a stock position, investors speculating on the long term growth of a stock up to 3 years out could choose to buy the stock's LEAPS call options instead. LEAPS call options cost only a fraction of the price of the underlying stock and allows you to capture as much profit as the delta value of those options allows you to. In fact, even if you choose to buy deep in the money LEAPS call options with delta value close to 1, it will still be much cheaper than buying the stock itself. Below is a picture of AAPL's January 2011 LEAPS options as of today, 6 April 2009.

AAPL LEAPS options

As you can see from above, you could control the gains on AAPL for almost 2 years using only $3020 towards the purchase of 1 contract of its $120 strike price LEAPS call options (nearest the money) or you could buy 100 shares of AAPL for $11,845. Its clear from here how much leverage LEAPS options is offering here. In fact, its deep in the money LEAPS call options with delta value of 0.7567, moving very closely with the price of AAPL, is asking only for one sixth of the price of AAPL shares. This is power of leverage in options trading.

There are two things an options trader could do with such options trading leverage; Risk Control and Leveraged Speculation. In terms of Risk Control, the investor who bought the $120 strike price LEAPS call options risked only $3020 even if AAPL should fall strongly while the investor who bought the AAPL shares have over $11,000 at risk at all times and could potentially lose a lot more than just $3020 should AAPL take a strong dip. In terms of leveraged speculation, the investor with $11,845 could now control up to 300 shares of AAPL through buying 3 contracts of its $120 strike price LEAPS call options while that same $11,845 would only buy only 100 shares of AAPL. The investor who bought options controlled 3 times as many shares as the investor who bought the shares. Of course leverage is a double edged sword in options trading. Buying options with all $11,845 puts that whole fund at risk of falling to zero if AAPL falls below $120 by expiration of these LEAPS call options and isn't something we recommend.

Long Term Hedging
LEAPS Options could be used for long term stock hedging. Owners of shares could now either write out of the money LEAPS call options against their shares in order to provide moderate downside protection for their stocks ( Covered Call) or they could purchase LEAPS put options as long term insurance against a catastrophic fall ( Married Put).

Hedging with LEAPS options significantly reduce the cost of long term hedging due to lower price and commissions. In terms of price, LEAPS put options cost much lesser than all the short term monthly put options added together. This is why investors seeking to hedge for the long term should not hedge using short term put options. Hedging using short term options also result in more trades as short term options expire, resulting in higher commissions cost.

Long Term Options Strategies
LEAPS Options are also used widely in long term options strategies such as the Calendar Call Spread or Diagonal Ratio Spreads due to its time advantage and much lower time decay ( theta) compared to short term options.

LEAPS Options Expiration Cycle

One can tell if a long term option is a LEAPS option or not in options trading by looking at its expiration month. All LEAPS Options expire on January. Any long term options with expiration of more than 9 months out but not on January are not LEAPS options.

Availability of LEAPS Options

Not all optionable stocks have LEAPS options listed. Due to the relatively low level of interest in long term options, it may not be profitable or practicable for market makers to maintain an inventory of LEAPS options for every optionable stock and index. As such, LEAPS options are currently available for only about 450 heavily traded equities and 10 indices (2009). One of the most popular so far would be the LEAPS options on QQQQ, which is an ETF that tracks the Nasdaq-100 index.

For a list of stocks and index with LEAPS options, please refer to the CBOE LEAPS Symbol Directory.

LEAPS options Specifications

Here are the specifications that define LEAPS Options:

Symbol : All LEAPS Options symbols contains the letters "L", "V", "W" or "Z" right in front. Looking at the Jan2011 LEAPS Options chain of AAPL above, you can see that all of them start with the letter "V". Any long term options with symbols that do not begin with these letters are not LEAPS options.

Contract Size : 100 shares of the underlying per contract. This is exactly the same as any standardized options trading in the US market.

Strike Price Interval : 2.5 points when the strike price is between $5 and $25, 5 points when the strike price is between $25 and $200, and 10 points when the strike price is over $200. Strikes are adjusted for splits, re-capitalizations, etc.

Expiration Date : Saturday immediately following the third Friday of the expiration month. This is exactly the same as the other plain vanilla standardized options.

Expiration Months : Up to 39 months from date of listing with January expiration only.

Exercise Style : American. Can be exercised prior to expiration.

Pricing of LEAPS Options

Pricing of LEAPS Options, in terms of its extrinsic value, is trickier than pricing of short term options due mainly to the effects of interest rate and volatility.

Interest rate affects the extrinsic value of short term options only minimally but is an important component when pricing LEAPS options. The main challenge is in the estimation of where interest rates will be in 2 to 3 years time. Short term options uses the prevailing risk free interest rate in its pricing while the pricing of LEAPS Options requires an estimate of where interest rates will be in 2 to 3 years time. If the economy is expected to start a cycle of interest rate increases, LEAPS call options would have significantly higher extrinsic value than LEAPS put options as increases in interest rate increases the value of call options and decreases the value of put options.

Volatility is a major component in the price of both long and short term options. While the implied volatility of short term options can be easily estimated, long term options need to take long term volatility into consideration and that's where it becomes tricky. So far, there are no easy or totally accurate ways of estimating future volatility 2 to 3 years out, which is what makes the pricing of LEAPS options so difficult as well. As such, LEAPS options tend to have extremely high VEGA which result in its extreme sensitivity to changes in implied volatility. This could lead to a situation where LEAPS call options bought during a period of extremely high volaility may find it hard to profit as the bull trend resumes, crushing implied volatility on the way up.

You may also wish to read the full tutorial on Stock Options Pricing.

LEAPS options Strategies

Here is a summary of some of the most popular options trading strategies using LEAPS options:

Long Call : This is the straight forward purchase of LEAPS call options in anticipation of a long term bull trend.

Bull Call Spread : LEAPS options are expensive. That is why many options traders also short out of the money LEAPS call options in order to reduce capital outlay.

Long Put : This is the straight forward purchase of LEAPS put options in anticipation of a long term bear trend.

Bear Put Spread : Again, LEAPS put options are expensive. That is why many options traders short out of the money LEAPS put options in order to reduce capital outlay.

Rolling LEAPS Options : Where a 2 or more years LEAPS option is held til it has about 1 year left to expiration and then sold while simultaneously buying a similar LEAPS Options with a new 2 years or more to expiration. This way, long term buy and hold investors could simulate a synthetic protective put position for long term investment.

Calendar Call Spread : LEAPS options decays much slower than short term options do. As such, options traders holding LEAPS options frequently write short term out of the money options against their LEAPS options in order to benefit from the difference in time decay of extrinsic value.

Advantages of LEAPS options

:: Longer expiration date allows for long term speculation and hedging
:: Slow time decay allows for profitable calendar spreads
:: Provides leverage for long term investing
:: Much cheaper than buying short term options month to month for extended period

Disadvantages of LEAPS options

:: Much more expensive than short term options and unnecessary for short term options trading
:: You don't get dividends for owning LEAPS call options on dividend paying stocks
:: Extreme sensitivity to implied volatility may result in reduction in value as implied volatility drops on improving economic outlook

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