All you need to know about Long term equity anticipation securities and how they are taxed
All you need to know about Long term equity anticipation securitie:
WHAT ARE LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS)?
LEAPS can simply be defined as option-enabled contracts publicly traded for a period and whose duration before expiration is longer than one year. It is mostly longer than the traditional options which usually expire within three to nine months.
The contract duration of long-term equity Anticipation securities is usually within the range of one to three years with the most obtainable time limit being two years maximum.
LEAP initially was obsolete not until the year 1990 when it was first introduced by the Chicago Board Options Exchange (CBOE) and ever since then, it has become a popular contract medium.
HOW DO LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) WORK?
LEAPS only trade on selected optionable stocks and indexes which are always listed by the CBOE in May, June, and July of every year, and more like other contract options, LEAPS gives a buyer the purchasing right, but must be purchased from either a broker-dealer or trading network but not the right to buy or sell the inherent assets at the already determined price (Depending on whether the option is a call or put) before or after the expiration date.
The equity options for leaps usually reach their expiration date on Saturday following the third Friday of every January of every year and it is done on every business day before the expiration date.
WHAT ARE LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) USED FOR?
- LEAPS gives investors the opportunity to
Diversify their respective portfolios
- LEAPS helps investors Hedge their investment options for a long time to avoid possible future losses on an investment.
- LEAPS helps investors Partake in long or medium-term changes in security prices without making a purchase.
WHAT IS AN EXAMPLE OF LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS)
LEAPS can be likened to an investor who owns shares of NOP limited and wants to hold them for a long period but Is afraid that the stock price might fall below.
To avoid these concerns, the investor will purchase LEAPS puts on NOP LIMITED to protect its investment against unfavorable conditions on the long stock position.
LEAPS puts saves the investor against a reduction in price values without short-selling shares in the underlying stocks.
In real life example;
Let say an investor wants to buy 2,000 shares of NOP LIMITED, with a current market price of $10 that the investor previewed will increase in the future.
So instead of investing all the money, the investor will LEAPS call, and then purchase 10 contracts, buying 200 shares for every 10 contracts with a premium of $4 and a strike price of $14. The investor will have to pay the premium of $8,000 (4*2000 shares).
So assuming the market price increases to
$22 per share, the investor will opt for a call option and buy the share at a strike price of $14 and sell the share at the same current market price of $22, which will give a profit of (($22 – $14 – $4) * 2,000).
But assuming the market price did not increase, more than the strike price within the time limit of the LEAPS options, in such case, the investor will not opt for the call option which will lead to loss of the premium amount which is ($8,000) in our above example.
WHEN SHOULD YOU BUY A LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS)?
Due to option sensitivity to changes in interest rate, option prices, and the sensitivity of implied volatility in the market which can be very high for LEAPS, investors should buy when the implied volatility in the market is relatively very low.
HOW ARE LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) TAXED?
LEAPS are taxed irrespective of the duration in which the contract was held.
A LEAPS seller is taxed on the long term of the capital gain rate if the contract was held for at least a year and a day and if the contract was held for a shorter period, the seller would be subject to a short-term capital gains rate.
Consequently, if an investor opts for a LEAP call option or a LEAP put, the investor who sells stock at the LEAP’s strike price and makes a profit would pay capital gain tax based on the amount of time the actual shares were owned regardless of the duration of the contracts and vice versa.
TYPES OF LONG TERM EQUITY ANTICIPATION SECURITIES (LEAPS)
LEAPS is divided based on the options which are:
- LEAPS calls and LEAPS puts
LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) calls
This is when an investor exercises its options of purchasing the assets or shares at the predetermined stock at the strike price within the duration of the contract and it is exercised when the market value is higher than the strike prices.
LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) puts
This is when an investor sells the asset at a given price before the expiration of the contract and it is exercised when the market value is lower than the strike price.
BENEFIT & DISADVANTAGES OF LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS)
BENEFITS OF LEAPS
- It gives traders the leverage to participate in the stock price
- it allows the trader to partake in its long trend without shorter options contracts which are labor-saving and cost-effective
- Due to its long-term duration, the investors of LEAPS feel less pressure from short-term market fluctuations.
- It is available for equity indices
- It helps to hedge a long term portfolio
DISADVANTAGES OF LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS)
- It has a higher premium which gives rise to drawbacks that are not suitable for all investors
- The longer the duration of contracts, the higher the risk
LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) Vs SHORTER TERM CONTRACTS
- LEAPS is longer than short term contracts by the duration
- LEAPS gives investors time to be right about the direction of stock and market prices while Short term contracts do not give investors the leverage
- Due to a long time added value of LEAPS, it makes LEAPS more expensive than short term contracts
- Maximum loss is greater in LEAPS than in short term contracts
- LEAPS are available on thousands of stocks while LEAPS are not available in all short term optionable stock
LONG-TERM EQUITY ANTICIPATION SECURITIES (LEAPS) Vs STOCKS
- LEAPS allows investors to utilize a smaller degree of capital when compared to buying the stock outright and this puts LEAPS in the position to earn bigger returns if predicted right than Stock.
- LEAPS cost less than stocks
- LEAPS tend to move in with price than Stocks
- LEAPS allow investors to control a large number of shares with less money than Stocks
- When purchasing LEAPS, the maximum loss is the cost of the option while the maximum loss when buying Stocks is the result of the stock going to Zero.
- LEAPS have a longer time of expiration than Stocks.
Though LEAPS have longer expiration dates of an options contract, it is however very imperative for an investor to trade with caution when using LEAPS and it is also good for one to have in-depth knowledge about LEAPS before trading. Before getting involved in LEAPS, one should take time and properly assess the risks involved.