You can structure your investment with long-term equity anticipation securities (LEAPS) if you're bullish on a particular company’s stock. A rise of 50% could translate into a 300% gain, but this strategy comes with risks, and the odds are stacked against you. It can wipe out your entire portfolio in a matter of days when it's used foolishly. Used wisely, however, it can be a powerful tool that allows you to leverage your investment returns without borrowing money on margin.
- Using long-term equity anticipation securities (LEAPS) with an expiration period of up to three years can be an alternative to buying stocks outright.
- Using LEAPS can result in huge returns, but they can be risky, and you’ll have to roll the dice just right.
- This investment position makes sense if you believe that the stock will be worth much more than the current market price before your options expire.
- Using LEAPS shouldn’t be considered if you can’t sustain significant losses and don’t have a complete portfolio.
What Are LEAPS?
LEAPS are long-term exchange-traded options with an expiration period of up to three years. Acquiring them 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.
LEAPS vs. Simply Buying Stock
Suppose you want to purchase several shares of Company XYZ. It's trading at $14.50, 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 options. You can purchase the stock outright, buy it on margin, or use LEAPS.
Buying on margin involves borrowing money from your broker and pledging your shares as collateral for the loan. It might sound convenient, but you could ultimately lose more money than you've invested.
Buying 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 to 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.
You'll also have to pay interest for the privilege of borrowing that money on margin.
You might consider using LEAPS instead of the common stock if you don't like this level of exposure. First, you would look to the pricing tables published by the Chicago Board Options Exchange (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, or premium, for this option. The call options are also sold in contracts of 100 shares each.
A call option gives you a defined period of time during which you can buy shares at the strike price.
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 rounded 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.
How LEAPS Could Work
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 years, and you'll have a 100% loss of capital if it trades below your $17.50 call strike price.
- You could call your broker and close out your position if the stock does rise substantially.
- You could force someone to sell you the stock for $17.50 per share 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 $6 per share—the capital gain of $7.50 minus the $1.50 you paid for the option—if it were to rise to $25.
The Outcome Using LEAPS
Your net profit on the transaction would be $6 per share on an investment of only $1.50 per share. You turned a 72.4% rise in stock price 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.
The Temptations and Dangers of Using LEAPS
Using LEAPS doesn't make sense for most investors. They should only be used with great caution and by those who:
- Enjoy strategic trading
- Have plenty of excess cash to spare
- Can afford to lose every penny they put into the market
- Have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy
The biggest temptation when using LEAPS is to turn an otherwise good investment opportunity into a high-risk gamble by selecting options that have unfavorable pricing or would take a near miracle to hit the strike price.
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 a speculator has made an absolute mint.
Frequently Asked Questions (FAQs)
How do you buy LEAPS?
To buy LEAPS, you'll need a brokerage account with permissions to buy call options contracts. It's up to each brokerage to decide when to let you buy calls, but the factors in their decision will include your experience as a trader and your total equity in the account.
How are LEAP options taxed?
Just like holding stocks outright, LEAPS are eligible for the more favorable long-term capital gains tax rate. Most of those who hold onto a LEAP option for more than one year before selling are taxed at either 0% or 15% (though high-income individuals may be taxed up to 20%). The gains from LEAPS sold exactly one year after buying (or sooner) are taxed at your normal income bracket rate.
When do new LEAPS come out?
New LEAPS come out a little more than two years before the calendar year of expiration. For example, LEAP options that expire in 2024 are scheduled for release on Sept. 13, 2021. LEAPS that expire in 2025 will be released in late 2022.