LEAPS

In short

You have probably heard someone mention LEAPS and wondered if it was just a fancy word for a regular option. It is not, quite. A LEAPS is a long dated options contract, meaning a contract whose expiration date is generally more than a year away at the time it is listed. That extra time is the whole point. It gives a stock, or an index, room to move without the clock crushing you right away. If you are the kind of person who thinks in years rather than weeks, knowing how LEAPS work can help you make a more honest plan.

The whole of it

What it is

I once watched a neighbor pay a small deposit to hold the price on a house he planned to buy the following spring. He was not buying the house that day. He was buying time and a locked in price. A LEAPS call option works almost the same way. You pay a premium, which is just the price of the contract, and in return you get the right to buy one hundred shares of a stock at a set price, called the strike price, before a set date that is at least a year away. A LEAPS put gives you the right to sell instead of buy. You are not required to do either. That is what the word option means.

If you are holding a brokerage statement right now and trying to make sense of the name, here is the plain version. LEAPS stands for Long Term Equity AnticiPation Securities. The name sounds complicated. The idea is not. It is a regular listed option with a longer expiration date. The Options Clearing Corporation, which is the clearinghouse that stands behind every listed option in the United States, treats LEAPS the same as any other option once they get close to expiration. They simply convert to standard options at that point.

How it works

A friend of mine always said that time is either working for you or against you in options. With a LEAPS, you are buying yourself more of it. When you buy a call LEAPS, you pay the premium upfront. That premium is yours to lose if things go badly. The seller of the contract collects that premium and takes on the obligation to deliver shares if you exercise your right. Most LEAPS buyers never exercise. They either sell the contract before expiration or let it expire worthless.

You have probably wondered what goes into the price you pay. Any option, including a LEAPS, carries two parts in its premium. The first part is intrinsic value, which is simply how far in the money the option already is. If a stock trades at 50 dollars and your strike price is 45 dollars, your call has 5 dollars of intrinsic value. The second part is time value. This is the portion of the premium that reflects the possibility of future movement. With a LEAPS, time value is large at first because expiration is far away. As each month passes, that time value slowly shrinks. Traders call this shrinkage theta decay, which just means the clock is always eating a little of your premium.

You have probably heard the word leverage in a financial context. A LEAPS gives you exposure to one hundred shares for a fraction of what buying those shares outright would cost. That cuts both ways. Gains can be large relative to what you paid. So can losses.

The numbers, and where to find yours

A friend of mine once nearly made a costly mistake because he forgot to multiply by one hundred. If you are looking at a specific LEAPS contract today, keep this in mind. The premium you see is quoted per share, but each contract covers one hundred shares. So a premium of 4 dollars means you pay 400 dollars for one contract, not 4 dollars. Always multiply by one hundred.

If you want to know what expiration dates are available right now, the exchange sets that calendar. The Chicago Board Options Exchange, known as CBOE, lists expiration dates and contract details on its public site at cboe.com. The Options Clearing Corporation publishes contract specifications at theocc.com. Those are the places to verify what you are actually reading on a brokerage screen.

You may be wondering whether the government caps how much you can put into a LEAPS the way it caps retirement contributions. It does not. There is no single government set dollar limit on LEAPS. The cost is whatever the market charges at the moment you buy. What the government does regulate is how options are taxed. The Internal Revenue Service has specific rules about options holding periods and whether gains count as short term or long term. IRS Publication 550 covers investment income and expenses, including options, and it is free at irs.gov. Read it, or have a tax professional read it with you, before you close your first LEAPS trade.

A worked example

Maria is thirty four years old and she has been watching a company she believes in for two years. The stock trades at 80 dollars a share. Buying 100 shares outright would cost her 8,000 dollars. She does not want to commit that much cash right now. She looks at a LEAPS call option with a strike price of 85 dollars expiring about eighteen months from now. The premium is 6 dollars per share. She pays 600 dollars for one contract.

Eighteen months later the stock has climbed to 110 dollars. Her contract gives her the right to buy at 85 dollars. The intrinsic value alone is now 25 dollars per share, or 2,500 dollars for her contract. She sells the contract rather than exercising it. Her gain before taxes and commissions is 1,900 dollars on a 600 dollar outlay. She is happy but she is careful to talk to her tax preparer because the IRS rules on options gains can surprise people.

Now suppose the stock stayed at 80 dollars the whole time and drifted to 78 dollars near expiration. Her contract expires worthless. She loses all 600 dollars. That is the full risk she accepted when she wrote the check. No more, no less.

Here is every number laid out so you can trace it yourself. Gain scenario: sale price 2,500 dollars minus purchase price 600 dollars equals 1,900 dollars. Loss scenario: 600 dollars paid minus 600 dollars lost equals zero dollars remaining. Both answers follow directly from the inputs.

Where it goes wrong

I once sat with a man who bought LEAPS convinced that having more time meant having less risk. More time is not the same thing. The premium you pay is real money. Gone is gone. A LEAPS can expire worthless just as fast as a short dated option if the stock moves the wrong way or simply sits still.

If you have priced a short dated option lately, you may be surprised by how much more a LEAPS costs. That extra cost is real. Time value costs money. You are paying for all those extra months, and the market prices that in from the start.

A quieter problem is one that catches many people off guard. Some LEAPS contracts trade very little volume. A wide spread between the buy price and the sell price means you give up real money just entering and exiting the trade. Check the bid ask spread before you commit. Narrow is better.

Taxes deserve a careful look before you do anything else. Options taxation is not simple. Do not assume a gain on a LEAPS is automatically a long term capital gain. The IRS rules depend on how and when the contract was closed or exercised. IRS Publication 550 is the honest starting point.

Questions to answer before you leave this page

Before you move on, it is worth sitting quietly for a moment and asking yourself a few honest questions, because the answers will tell you more than any article can: Do you understand that the entire premium you pay can vanish, and are you at peace with that specific dollar amount being gone? Have you read the contract details on CBOE or through the Options Clearing Corporation so you know exactly what expiration date and strike price you are considering? Have you looked up IRS Publication 550 or spoken with a tax professional about how a gain or a loss on this contract would affect your return? Do you know the bid ask spread on the contract you are eyeing, and have you decided whether that spread makes the trade honest for your situation? And finally, and I think this is the one most worth sitting with, are you buying a LEAPS because you have a clear and patient reason to believe in the underlying stock over a long stretch of time, or are you buying it because the idea of leverage sounds exciting right now?