Let's Talk About LEAPS: Options For The Long Term--from Brainteaser

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INTRODUCTION
When considering any options strategy, you may want to think about Long-Term Equity Anticipation Securities (LEAPS) if you are prepared to carry the position for a longer term.

While using LEAPS does not ensure success, having a longer amount of time for your position to work is an attractive feature for many investors. In addition, there are several other factors that make LEAPS useful in many situations.

STOCK ALTERNATIVE
LEAPS offer investors an alternative to stock ownership. LEAPS calls enable investors to benefit from stock price rises while placing less capital at risk than is required to purchase stock.

Should a stock price rise to a level above the exercise price of the LEAPS, the buyer may exercise the option and purchase shares at a price below the current market price. The same investor may sell the LEAPS calls in the open market for a profit.

DIVERSIFICATION
Investors also use LEAPS® calls to diversify their portfolios. Historically, the stock market has provided investors significant and positive returns over the long term. Few investors purchase shares in each company they follow.

A buyer of a LEAPS call has the right to purchase shares of stock at a specified date and price up to three years in the future. Thus, an investor who makes decisions for the long term can benefit from buying LEAPS calls.

HEDGE
LEAPS puts provide investors with a means to hedge current stock holdings. Investors should consider purchasing LEAPS puts if they are concerned with potential price drops on stock that they own. A purchase of a LEAPS put gives the buyer the right to sell the underlying stock at the strike price up to the option's expiration.

WHAT'S THE DOWNSIDE?
If you are a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price you paid for the position. If you are an uncovered seller of LEAPS calls, there is unlimited risk, or a seller of LEAPS puts, significant risk.

Risk varies depending upon the strategy followed, and it is important for an investor to understand fully the risk of each strategy.

STOCKS VS. LEAPS
There are many differences between an investment in common stock and an investment in options. Unlike common stock, an option has a limited life.

Common stock can be held indefinitely, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument.

As a result, even if an option investor correctly picks the direction the underlying stock will move, unless the investor also correctly selects the time frame that movement will take place, the investor will not profit as desired.

LEVERAGE
Options investors run the risk of losing their entire investment in a relatively short period of time and with relatively small movements of the underlying stock.

Unlike a purchase of common stock for cash, the purchase of an option involves "leverage," whereby the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.  


WHAT ARE LEAPS?
LEAPS are simply long-term options that expire at dates up to 2 years and 8 months in the future, as opposed to shorter-dated options that expire within one year.

LEAPS grant the buyer the right to buy, in the case of a call, or sell, in the case of a put, shares of a stock at a predetermined price on or before a given date.

Equity LEAPS are American-style options, and therefore may be exercised and settled in stock prior to the expiration date. The expiration date for Equity LEAPS is the Saturday following the third Friday of the expiration month.

HOW LEAPS WORK
LEAPS are quoted and traded just like any other exchange listed option. In fact, many of the features of LEAPS® are the same for shorter-term options:

• Number of shares covered by the contract (100)

• Exercise and assignment procedures

• Trading procedures

• Margin and commission costs

However, LEAPS differ from shorter-term options in several ways including availability, pricing, time erosion vs. delta effect, symbols and strategies.  

THE AVAILABILITY OF LEAPS
Several factors impact the availability of LEAPS. When options are listed for trading on a particular stock, most times LEAPS are not immediately available.

After a period of time, and if interest warrants it, the exchanges listing the shorter-term options may decide to list LEAPS options, after consulting with the market-makers or specialists assigned to trade the stock options.

The reason for this is that LEAPS options are difficult to price because of their long life. The exchanges ensure that sufficient interest is present in the market, and that market-makers or specialists are prepared to price and trade longer-dated options once they are listed.

The result is that LEAPS are not available on every stock which has options traded on it. LEAPS are initially listed with three strike prices, at the current price and 20 to 25% above and below the price of the underlying stock.

Strikes may be added as the underlying stock moves. LEAPS only have one expiration month: January in two different years.

As LEAPS draw within one year of their expiration and it becomes necessary to list new LEAPS series, the existing LEAPS options continue to be listed and traded until their expiration.

However, because of the shorter length of time until expiration, they then trade as ordinary shorter-term options and they lose their distinctive LEAPS symbols. New LEAPS options with expiration dates in the future are then added.

In order to determine if LEAPS® are available on a stock that interests you, consult our Directory of Listed Options (xls format). LEAPS® account for approximately 10% of all options listed. LEAPS® are proving themselves very attractive to an ever-increasing number of options investors and traders.

HOW TO PRICE LEAPS
Options pricing models contain five factors that are used to determine a theoretical value for an option: stock price, strike price, time to expiration, interest rates (less dividends) and volatility of the underlying stock.

With shorter-term options, it is fairly straightforward to use an interest rate which approximates the "risk-free" interest rate; most people use the U.S. Treasury-bill rate (90-day).

However, to price a LEAPS option, it is necessary to predict the volatility (expectation of price fluctuation) of the underlying stock and interest rates over 2 ½ years; this is difficult even for most professionals.

In short, pricing longer-term options is more difficult than pricing shorter-term options. Of the five factors mentioned above, interest rates play a more significant role in the pricing of longer-dated options, due to the length of time involved.

For these reasons, professionals are not ready to instantly quote prices of options with maturity dates far into the future, since the predictability of the inputs is so much more unreliable than for shorter-term options.

Despite these difficulties, investors will find that exchange policies generally require market-makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS whenever the decision is made to use them.  

UNDERSTANDING LEAPS SYMBOLS
In order to differentiate LEAPS from shorter-dated options, LEAPS have a different set of symbols for retrieval on quotation systems. While other options have fixed symbols, LEAPS symbols change to reflect the expiration year.

Options
    Symbol       LEAPS Option              Symbol
OCT ('02) 15 call    MOT JC        JAN ('04) 15 LEAPS call   LMA AC

JAN ('03) 15 call     MOT AC       JAN ('05) 15 LEAPS call   ZMA AC    

This feature makes it easy to distinguish a longer-term option from a shorter-term option in data listings. To obtain a symbol for a LEAPS option access OIC's Directory of Listed Options (XLS).

ERODING TIME PREMIUM
One of the most challenging aspects of shorter-term options is the erosion of the "time premium" portion of the option's price. Time premium refers to the amount of the option's price that exceeds its intrinsic value.

As an option nears its expiration date and the time period shortens, the marketplace is less and less willing to pay any premium over intrinsic value until, at expiration, an option is trading purely for intrinsic value.

As a seller of shorter-term options, time premium erosion works in your favor. Conversely, the option buyer has to overcome the erosion of time premium to make a profit from a long option position. The graph below is a representation of theoretical time erosion for longer-dated options:

TIME DECAY OVER TIME

CLICK HERE TO VIEW TIME DECAY GRAPH
(Note: The prices presented in this graph are for illustrative and educational purposes only. They do not represent any actual options prices and are not intended to. Options prices on actual stocks may differ significantly from those shown.)

As you can see from the graph, time erosion of options premium is not linear (i.e. it does not occur in a straight line). The mathematical reasons for this are complex, but the result is that the erosion of time premium in the earlier months of an option's life is much less dramatic than the erosion that occurs in the last few months.

Because of the long time frame of LEAPS options, this effect is even more pronounced. The time erosion that occurs in the first several months of a LEAPS option is minimal.

However, when LEAPS options become shorter-term options (time to expiration is less than one year), they behave like all other shorter-term options, as the graph shows. Time erosion becomes more pronounced and has a greater impact, especially in the last 90 days of the option's life.

LEVERAGE & THE DELTA EFFECT
What does this mean to options investors? Buyers of LEAPS options have less time premium erosion to fight than buyers of shorter-dated options. The tradeoff, however, is that LEAPS options offer less "leverage."

The deltas of LEAPS options will not increase dramatically as with shorter-dated options since there is so much time remaining until expiration. Any increase in option value due to an increase in the price of the underlying stock will be tempered by this lower gamma effect.

The slow time erosion will frustrate LEAPS sellers. However, the premiums available to writers, because of the increased time in LEAPS options, can provide a good rate of return in covered writing and other strategies.

LEAPS STRATEGIES
An investor anticipates that the price of ZYX stock will rise during the next two years. This investor would like to profit from the increase without having to purchase shares of ZYX.

ZYX is currently trading at 50½ and a ZYX LEAPS call option, with a two-year expiration and a strike price of 50, is trading for a premium of 8½ or $850 per contract. The investor buys five contracts for a total cost of $4,250, which represents the total risk of the call position.

The calls give the investor the right to buy 500 shares of ZYX between now and expiration at $50 per share regardless of how high the price of the stock rises.

To be profitable, though, at expiration, the stock must be trading for more than 58½, the total of the option premium (8½) and the strike price of 50.

The buyer's maximum loss from this strategy is equal to the total cost of the options or $4,250. The break-even point for this strategy is 58½.


THE FOLLOWING ARE POSSIBLE OUTCOMES OF THIS STRATEGY AT EXPIRATION:
Stock Above the Break-Even Point: If ZYX advances to 65 at expiration, the LEAPS will have a value of approximately 15 (the stock price of 65 less the strike price of 50). The investor may choose to exercise the calls and take delivery of the stock at a price of 50, or may sell the LEAPS calls for a profit.

• Stock Below the Strike Price: If ZYX, at expiration, is trading for less than the strike price, or below 50 in this example, the unexercised calls will expire worthless. In this case, the investor will incur the maximum loss of $4,250.

• Stock Between the Strike Price and the Break-Even Point: If ZYX, at expiration, has risen to 56, the calls will be valued at approximately 6 (the stock price of 56 less the strike price of 50) and will represent a partial loss given the break-even point of 58½. The calls purchased by the investor for 8½ will, upon exercise, then be worth approximately 6, creating a loss of 2½ points or $250 per contract. If the investor does not exercise or sell these options, the investor will lose all of the initial investment, or $850 per contract.

Prior to expiration, the LEAPS may trade at a price that is somewhat higher than the difference between the 50 strike price and the actual stock price. This difference is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration.

Time value is one of the components of an option premium and generally decreases as expiration approaches.

LEAPS PUTS
The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices. This strategy is often compared to purchasing insurance on one's home or car, and may give investors the confidence to remain in the market.

The amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost, should be considered.

For example, ZYX is trading at 45 and a ZYX LEAPS put with a three-year expiration and a strike price of 42½ is selling for 3½ or $350 per contract. These puts provide protection against any price decline below the break-even point, which for this strategy is 39 (strike price less the premium).

The investor's risk or maximum loss is limited to the total amount paid for the put options or $350 per contract. The following are possible outcomes of this strategy at expiration.

• STOCK ABOVE THE BREAK-EVEN POINT: If ZYX is trading at 48 at expiration, the unexercised put would generally expire worthless, representing a loss of the option premium or $350 per contract.

• STOCK BELOW THE STRIKE PRICE: The put would be profitable if the stock closed below 39 at expiration. If ZYX is trading at 37½ at expiration, the 42½ put, upon exercise, would have a value of 5 or $500, representing a profit of 1½ points or $150 per contract. This profit will partially offset the decline in the value of the stock.

• STOCK BETWEEN THE STRIKE PRICE AND THE BREAK-EVEN POINT: If ZYX is trading at 41½ at expiration, the 42½ put would be valued at approximately 1. This means that, upon exercise, a portion of the option premium would be retained and the loss would then be 2½ points or $250 per contract. If the contract is not exercised or sold, the investor will lose all of the initial investment, or $350 per contract.

SELLING COVERED CALLS USING LEAPS
The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.

The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.

(NOTE: Investors should be aware of the risks involved in a covered call strategy.)



The writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price.

The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.

The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS call. ZYX is currently trading at 39½, and a ZYX LEAPS call option with a two-year expiration and a strike price of 45 is trading at 3¼.

An investor owns 500 shares of ZYX at $39½ per share and sells five of ZYX LEAPS calls with a strike price of 45 at 3¼ each or a total of $1,625. The investor's objective is to obtain profits without selling the stock.

The break-even point for this covered call strategy is 36¼ (the stock price of 39½ less the premium received of 3¼). This represents downside protection of 3¼ points. A loss will be incurred if ZYX declines to below 36¼. Possible outcomes of this strategy at expiration are as follows.

• STOCK ABOVE THE STRIKE PRICE: If ZYX advances to 50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of 45 less the price of the stock when the option was sold plus the option premium received of 3¼ X 100).

• STOCK BELOW THE BREAK-EVEN POINT: If ZYX is trading at 34 at expiration, the unexercised LEAPS calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.

STOCK BETWEEN THE STRIKE PRICE & THE BREAK-EVEN POINT: If ZYX advances to 40 at expiration, the LEAPS calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of 3¼ per share.

martin1560

thanks!