LEAPS

LEAPS (an acronym for Long-term Equity Anticipation Securities) are a special class of options contracts with expiration dates that are much further into the future than standard options. While a typical option might expire in a few weeks or months, LEAPS have a lifespan of one to three years. They come in two flavours: call options (a bet that the price will rise) and put options (a bet that the price will fall). Think of them as giving you a very long runway to be right about a stock's future direction. For this extended time horizon, you pay a higher upfront cost, or premium, compared to a short-term option. This higher cost reflects the increased time value—essentially, you're paying for the luxury of time and the greater opportunity for the stock to make a significant move in your favour before the contract expires.

At their core, LEAPS function exactly like standard options, just with a much longer clock.

• A LEAPS Call gives the holder the right, but not the obligation, to buy 100 shares of an underlying stock at a predetermined price (the strike price) anytime before its distant expiration date. Investors buy these when they are bullish on a stock over the long term.
• A LEAPS Put gives the holder the right, but not the obligation, to sell 100 shares of a stock at the strike price before expiration. These are for investors who are bearish on a stock's long-term prospects.

The key difference is that the long lifespan dramatically changes the strategy. The slow rate of time decay (also known as theta decay) is a major advantage. With short-term options, time is a fierce enemy, as the option's value can evaporate quickly as expiration approaches. With LEAPS, time decay is much less of a factor in the early stages of the contract's life, allowing an investor's thesis to play out over months or even years.

While options are often associated with speculation, value investors can use LEAPS tactically, most famously through a “stock replacement” strategy. It’s a way to express a long-term, value-oriented view with less capital at risk.

Imagine you've analysed a company and believe its stock, currently trading at $100, is significantly undervalued and will be worth much more in two years.

• The Traditional Approach: Buy 100 shares for a total cost of $10,000 (100 shares x $100/share). Your maximum loss is the full $10,000 if the company goes bankrupt.
• The LEAPS Approach: Instead of buying the shares, you could buy one LEAPS call option with a strike price of $100 that expires in two years. This contract controls 100 shares. Let's say the premium for this option is $20 per share, for a total cost of $2,000 ($20 x 100 shares).

• Capital Efficiency: You gain exposure to the stock's potential upside for just $2,000 instead of $10,000. The remaining $8,000 is freed up to invest elsewhere, improving your diversification. This is a form of leverage.
• Defined Risk: Your maximum loss is capped at the $2,000 premium you paid. If the company performs poorly and the stock price falls to $50, the traditional investor has lost $5,000 on paper. You, the LEAPS holder, have only lost your initial $2,000 investment.

For a value investor, using LEAPS as a stock substitute is not a free lunch. It changes the nature of the investment.

1. No Ownership Rights: As an option holder, you are not a shareholder. You do not get to vote, and more importantly, you do not receive any dividends. If the company pays a hefty dividend, that's a return you are forgoing.
2. The Breakeven Hurdle: For the LEAPS trade to be profitable at expiration, the stock doesn't just need to rise; it needs to rise above the breakeven point, which is the strike price plus the premium paid. In our example, the stock must be above $120/share ($100 strike + $20 premium) for you to make a profit.
3. Finite Lifespan: Value investing icons like Warren Buffett often talk about a holding period of “forever.” LEAPS fundamentally conflict with this, as they have a hard expiration date. They are a tool for a specific thesis with a time limit, not a true long-term “buy-and-hold” investment.

• What They Are: LEAPS are simply options contracts with long-term expiration dates (1-3 years).
• How They're Used: Primarily to make long-term bets on a stock's direction with less capital than buying the stock outright.
• For Value Investors: The stock replacement strategy offers a capital-efficient, risk-defined way to act on a value thesis.
• The Downsides: LEAPS have a finite life, are subject to time decay (albeit slowly), do not provide dividends or ownership rights, and require the stock to outperform a breakeven price. They are a powerful tool but must be used with a clear understanding of their unique risks and limitations.