This week's strategy was written by James B. Bittman and was provided by

The Options Industry Council

Why Not LEAP into a Stock?

Afraid to be in the market and afraid to be out? Is there a way to get the best of both worlds?

Recent volatility in the markets has made many investors skittish about being too heavily invested in equities, yet these same investors are reluctant to discontinue purchasing stocks because of their superior performance for a number of years. A simple strategy using LEAPS^® call options may be just what the investment doctor ordered!

This article will start with a little background on LEAPS^® options, what they are, how they differ from regular options, and why there was a demand for them. Second, an example will show how LEAPS^® calls might be used to participate in a stock’s price rise and limit risk at the same time.

Background Information

LEAPS^® is the acronym for Long-term Equity AnticiPation Securities. That’s a fancy name for what are simply long-term call and put options. These options have expirations of up to three years from the time they are listed, while traditional options have expirations of not more than nine months. LEAPS^® were introduced in 1990 on only a few large-cap stocks, but they are now available on over 200 stocks.

So, are LEAPS^® just options with longer-dated expirations? Yes and no.

While LEAPS^® are similar to standard options, there are differences in dynamics and in contract specifications.

Differences in Contract Specifications

Fewer Strike Prices and Expiration Months

LEAPS^® are initially listed with only three strike prices available. One is at-the-money; one is approximately 20% out-of-the-money; and one is approximately 20% in-the-money. Additional strikes are added as the price of the underlying stock changes and the highest or lowest strike becomes at-the-money. LEAPS^® options also have only one expiration month, January, but there are always two expiration years available.

Different Symbols

Standard options have fixed root symbols. The root symbol for short-term options on Microsoft stock, for example is "MSQ." LEAPS^® options on Microsoft, however, have different root symbols for different years. "ZMF" is the root symbol for Microsoft LEAPS^® expiring in January, 2001, and "WMF" is the root symbol for Microsoft LEAPS^® expiring in January, 2002. A complete list of LEAPS^® options and their root symbols can be found in the "Directory of Exchange Listed Options" which is available from The Options Industry Council and on their Web site, www.optionscentral.com.

Differences in Dynamics

Generally, the longer the time to an option’s expiration, the lower the cost of an option’s time premium on a unit-of-time basis. Table 1 compares the premium of a six-month at-the-money call to a two-year at-the-money LEAPS^® call.

TABLE 1

Note: Prices are estimated using a standard Black-Scholes model assuming a $50 stock price, a $50 strike price, interest rates of 5%, zero dividends and days to expiration of 180 (six months) and 730 (two years).

In Table 1, the cost-per-month of the two-year LEAPS^® call is nearly half that of the six-month call. The conclusion is that LEAPS^® hold their time value relative to traditional short-term options, and this is an important reason why there was demand for them. The concept of how LEAPS^® hold their time value is illustrated graphically in Graph 1.

Graph 1

Assumptions: Stock price, $100; strike price, $100; volatility, 30%; interest rates, 5%; Dividends, $0.

While these are the main differences between LEAPS^® and traditional short-term options, there are other differences depending on the strategy being used. LEAPS^®, of course, may not be suitable for everyone, but if you understand them and use them properly, they may help you to increase capital and provide protection for profits, positions and portfolios. Now let’s look at a basic strategy using LEAPS^® calls.

LEAPS^® AS A STOCK SUBSTITUTE

The following example illustrates two concepts. The first concept is that an in-the-money LEAPS^® call can be expected to move very closely with its underlying stock as that stock rises in price. The second concept is that the cost and maximum potential risk of the LEAPS^® call is significantly less than the cost and risk of the underlying stock. The result, in this example, is that a two-year exposure to a stock can be purchased for a reduced investment. While both the LEAPS^® call and a long stock position face the risk of a declining stock price, the investment dollars at risk with the LEAPS^® call is considerably lower.

The positions below compare results between stock ownership and an in-the-money LEAPS^® call on the stock. Remember, the owner of a LEAPS^® call does not have the right to receive dividends or to vote in corporate affairs. Note also that the number of LEAPS^® calls equals, on a share-for-share basis, the number of shares of stock that is purchased, i.e., one LEAPS^® call for each 100 shares of the underlying stock.

It is obvious that the LEAPS^® call costs less than the long stock position, but compare the results under three different scenarios:

XYZ stock rises to $89 for a paper profit of $3,500 not including commissions. This is a 64.8% return on the $5,400 investment in the stock. The LEAPS^® call, however, rises to $49 (the stock price of $89 minus the strike price of $40) for a profit of $2,900 not including commissions. This is a 145% return on the $2,000 cost of the LEAPS^® call. The appreciation of the LEAPS^® call is $6 per share less in absolute dollar terms, but the initial investment was $3,400, or 62.9%, less.

Assuming funds are available, the owner of the LEAPS^® call has two choices. Should the LEAPS^® call be sold and the profit realized? If so, the tax consequences must be considered, and it is always best to consult a tax advisor in such matters. Or should the LEAPS^® call be exercised? Exercising means that the stock is purchased at the strike price. In this example, the strike price is $40 per share or $4,000 for 100 shares. After exercising, of course, the former LEAPS^® call owner becomes a stock owner and assumes all the risks of a long stock position.

XYZ stock falls to $19 for a paper loss of $3,500 not including commissions. This is a loss of 64.8% of the initial investment in the stock. With the stock at $19 at expiration, the LEAPS^® 40 Call expires worthless for a loss of $2,000 and 100% of the cost of the call. The dollar loss for the LEAPS^® call, in this example, is $1,500 less than for the stock position, but the percentage loss is greater.

Another consideration is that the LEAPS^® call no longer exists. With the stock position, however, the stock is still owned; and there is the possibility of a future price rise. Although there is also the risk of further losses from a continued stock price decline.

Assuming no dividends and no commissions, with the stock price unchanged, the stock owner has neither a profit nor a loss. A 40-strike LEAPS^® call, however, would have a value of $14 with the stock price of $54 at expiration. The purchaser of this call at $20 would have a $6 loss (per share) and a decision to make. Should the LEAPS^® call be sold and the loss realized? Or should it be exercised? Assuming funds are available to purchase the stock at the strike price, then exercising the call, as mentioned above, means that the former LEAPS^® call owner becomes a stock owner and assumes all the risk that a long stock position entails.

Graph 2 compares the two strategies. At expiration, the LEAPS^® Call breaks even, in this example, at a stock price of $60. The break-even price is calculated by adding the premium paid for the call, $20, to the strike price of $40. The maximum potential loss for purchasing the LEAPS^® call in this example is the $20 premium paid plus commissions.

Another Consideration

When using LEAPS^® calls (and regular calls, also) as a stock substitute, it is possible to take on "leverage" without realizing it. Leverage in investing means that the dollar value of the investment controlled is greater than the dollar value of the initial investment. Buying stock "on margin" is a common method of adding leverage. In the case of options, since option premiums are lower than the cost of the underlying stock, a given dollar amount could purchase options on more shares than the number of shares that could be purchased. Such an action would add leverage, whereas buying only the number of call options that represent the number of shares of the underlying stock you wish to purchase would not add leverage. If you are considering the purchase of 500 shares, for example, then you should buy only 5 calls. Buying more than 5 calls would add leverage and increase both your percentage profit potential and percentage risk potential.

Summary

Learning to use LEAPS^® options involves mastering new dynamics and new contract specifications.

Purchasing LEAPS^® calls as a stock substitute allows you to participate in the upside potential of a stock at a maximum risk that is substantially lower than the maximum risk of the long stock position. As a general rule, you should buy only the number of LEAPS^® calls that represents the number of shares of stock you would have purchased – i.e., one LEAPS^® call for each 100 shares of the underlying stock.

LEAPS^® options offer strategy alternatives that require a lower initial investment, that give a market forecast longer to be realized and that may reduce risk – all at the same time.

For more information on LEAPS^®:

1. Order LEAPS^® Video
2. Download The Options Toolbox

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker or from any of the exchanges listed on our home page. A prospectus, which discusses the role of The Options Clearing Corporation, is also available without charge from to The Options Clearing Corporation, 440 S. LaSalle St., Suite 2400, Chicago, IL 60605, or from any exchange on which options are traded.

The statements contained in this article reflect the opinion of the author and should not be taken as statements of fact or as opinions or recommendations of Accuinvest.com.