Index LEAPS Puts

Definition

The term index LEAPS put refers to the investment strategy involving the buying of a Long Term Equity AnticiPation Security when the stock market is thought to decline in value.  Index LEAPS puts differ from standard options only in terms of their expiration, which can be up to three years in the future.

Explanation

Index LEAPS provide investors with the opportunity to take a long-term position in the stock market without investing in an index.  They can also provide a hedge against a decline in the overall value of the stock market if the investor would like to protect their portfolio of securities.  If an investor anticipates an advance in the stock market over a long-term timeframe, they have the option of purchasing an index LEAPS, specifically a call.  If the investor anticipates a decline in the overall value of the stock market, and they own common stock, they can hedge their loss by buying an index LEAPS put.  In this manner, LEAPS can be used to lower an investor's loss of capital risk.

Example

An investor owns a portfolio of technology stocks worth $2,000,000 that very closely match the performance of the NASDAQ 100 Index.  While the investor believes the current bull market isn't over, they would like to protect the capital appreciation they've realized until the investor reaches retirement age in two years.  The current value of the NASDAQ 100 is right around $5,000, so one LEAPS put would protect $5,000 x 100 (multiplier), or around $500,000 of the portfolio; therefore, four contracts are needed.

The cost of this insurance with a strike price of $4,950 is $35, which means the investor would have to pay $35 x 100 x 4, or $14,000 for this three-year LEAPS put.  If the price of the NASDAQ 100 increases to $5,100, the value of the investor's profit would be:

= Ending Value of Portfolio - Starting Value of Portfolio - Cost of Index LEAPS Put
= $2,040,000 - $2,000,000 -$14,000
= $40,000 - $14,000, or $26,000

If the price of the NASDAQ 100 fell to $4,900, and the investor did not purchase the index LEAPS put, the investor's loss would be:

= Ending Value of Portfolio - Starting Value of Portfolio
= 1,960,000 - $2,000,000, or - $40,000

If the price of the NASDAQ 100 fell to $4,900, and the investor exercised their index LEAPS put at $4,950, the investor's loss would be:

= Ending Value of Portfolio - Starting Value of Portfolio - Cost of Index LEAPS Put + Profit on Index LEAPS Put
= $1,960,000 - $2,000,000 - $14,000 + $50 x 100 x 4, or
= $1,960,000 - $2,000,000 - $14,000 + $20,000, or
= -$40,000 -$14,000 + $20,000, or -$34,000

Related Terms

bull put spreads, bear put spreads, index LEAPS calls, bear call spreads