What Are LEAPS?
LEAPS is the acronym for long-term equity anticipation securities, a type of investment option with an expiration period of up to three years. Investing with LEAPS allows you to use less capital than you would if you were purchasing stock, and they can deliver outsized returns if you bet right on the direction of the shares.
How Investing With LEAPS Works
Let’s look at an example. Suppose you want to purchase several shares of Company XYZ. It’s trading at $14.50 per share, and you have $14,500 to invest. You’re convinced that XYZ will be substantially higher within a year or two, so you want to invest your money in the stock. You have three investment strategies to choose from:
Buying a Stock Outright or on Margin
You could simply buy 1,000 shares of the stock outright with your $14,500, or you could leverage yourself 2:1 by borrowing on margin, bringing your total investment to $29,000 and 2,000 shares of stock with an offsetting debt of $14,500. But you could be forced to sell at a loss if you were to get a margin call, if the stock were to crash, or if you were unable to come up with funds from another source to deposit into your account.
Using LEAPS
You might consider using LEAPS instead of the common stock if you don’t like this level of exposure. First, you would look at the pricing tables published by Cboe and see that you can purchase a call option for Company XYZ that expires two years from now, with a strike price of $17.50. That means you have the right to buy at $17.50 per share at any time between the purchase date and the expiration date. You must pay a fee (known as a premium) for this option. The call options are also sold in contracts of 100 shares each. Suppose you decide to take your $14,500 and purchase 100 contracts. Remember that each contract covers 100 shares, so you would then have exposure to 10,000 shares of Company XYZ using your LEAPS. Suppose you pay a premium of $1.50 per share. That’s $1.50 times 10,000 shares, or $15,000. You round up to the nearest available figure to your investment goal, but the stock currently trades at $14.50 per share. You have the right to buy it at $17.50 per share, and you paid $1.50 per share for that right, so your breakeven point is $19 per share. This scenario could play out in any of a few different ways:
You’ll suffer some loss of capital if the stock trades between $17.51 and $19 per share when the option expires in two yearsYou’ll have a 100% loss of capital if it trades below your $17.50 call strike priceYou could call your broker and close out your position if the stock does rise substantiallyYou could force someone to sell you the stock for $17.50 per share if it rises above that, and then immediately turn around and sell the shares you bought at the higher price per share if you elect to exercise your options. You’d pocket the difference per share—the capital gain above $17.50 minus the $1.50 you paid for the option.
The Result of Investing With LEAPS
If the share price rose to $25, your net profit on the transaction would be $6 per share on an investment of only $1.50 per share ($25 - $17.50 = $7.50 - $1.50 = $6). You turned a 72.4% rise in stock price ($25 - $14.50) into a 400% gain by using LEAPS instead. Your risk was certainly increased, but you were compensated for it, given the potential for outsized returns. Your gain would work out to $60,000 ($6 capital gain per share on 10,000 shares) for an initial investment of just $15,000, compared to the $10,500 you would have earned if you had bought 1,000 shares of the stock outright at a share price of $14.50, and it increased to $25 per share over time. Buying it on margin would have helped you earn $21,000, but you would have avoided the potential for wipe-out risk because anything above your purchase price of $14.50 would have been a gain. You would have received cash dividends during your holding period, but you would have been forced to pay interest on the margin you would have borrowed from your broker. It’s also possible that you could have been subject to the margin call if the market had tanked.
Risks of Investing With LEAPS
Using LEAPS doesn’t make sense for most investors. You should only use LEAPS if you have the ability to lose money without it impacting your financial situation. Use caution and consider these factors before investing with LEAPS:
You have experience with strategic tradingYou have excess cash to spare and can afford to lose every penny you put into the marketYou have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy
You might also be tempted to take on more time risk by choosing less-expensive, shorter-duration options that are no longer considered LEAPS. The temptation is fueled by the extraordinarily rare instances when an investor has earned a very large return.
