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LEAPS as an Alternative to Buying ETFs
07/03/2013 8:00 am EST
LEAPS can be used to create a long-term hedge against substantial declines in the underlying equities, notes Justin Kuepper of ETFdb.com.
Long-term equity anticipation securities (LEAPS) are long-term stock options with expiration dates set at least 12 months into the future. Long-term investors that normally shy away from traditional stock options can use LEAPS to gain long-term exposure to ETFs without actually spending the money to buy shares in them.
What Are LEAPS?
First introduced by the Chicago Board Options Exchange (CBOE) in 1990, LEAPS are publicly traded stock option contracts with expiration dates ranging from one to three years into the future. These options function are just like traditional shorter-term stock options, but their extended expiration dates make them ideally suited for long-term investors.
LEAPS are characterized by higher premiums than short-term stock options, since there’s more time for price movement to occur in the underlying stock. They also experience time decay just like normal stock options, although less so than traditional short-term stock options. In general, LEAPS are cheaper than rolling over short-term stock options over time.
How Can ETF Investors Use LEAPS?
LEAPS are commonly used as an alternative to owning stock in an underlying security, since their long-term nature enables an investor to benefit from long-term appreciation. Moreover, investors can buy LEAPS contracts for a fraction of the cost of purchasing the equivalent amount of underlying stock, creating a leveraged position that’s still long-term focused.
For example, an investor looking to buy 100 shares of the S&P 500 SPDR ETF (SPY) might pay $16,500, assuming it’s trading at 165.00. But, investors can buy the rights to 100 shares at 165.00 anytime between now and another date (up to three years in the future) for just $1,200 by purchasing the 165 LEAPS call options on the popular benchmark ETF.
LEAPS puts can also be used to create a long-term hedge against substantial declines in the underlying equities. For example, investors that wish to bet on a long-term decline in the US economy can purchase S&P 500 SPDR ETF LEAPS put options to complement their portfolio of international ETFs that they believe will outperform over that time.
LEAPS Versus Stock
There are several important differences between LEAPS and stock. LEAPS—like all stock options—have a limited lifetime that’s defined by their expiration date, while traditional stock can be held for an unlimited amount of time. If the LEAPS are not exercised before the expiration date, they can expire worthless and the investor can lose their entire investment.
LEAPS also involve more leverage than traditional stock, since the cost basis is low and the potential gains and losses are greater. The stock option can therefore experience greater volatility than traditional stock over time, while the LEAPS’ premium declines in value as the expiration date draws closer—since there’s less time for underlying price movement.
The Bottom Line
In the end, LEAPS are a great way for long-term investors to gain exposure to an ETF’s potential upside or downside over the long-term. But, leverage is a double-edged sword and the stronger potential gains on the upside are just as strong as the potential losses on the downside. As a result, investors should always be aware of the risks before buying a LEAPS position.
By Justin Kuepper, Contributor, ETFdb.com
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