Options 101: Lovin' LEAPS

              

In a recent edition of Options 101, we learned how to the crack the option code, as dissecting option symbols can often feel like reading Chinese. In today's column, we're going to turn our attention to a happy medium between aggressive, short-term options trading and traditional stock buying: Long-term Equity AnticiPation Securities, more commonly referred to as LEAPS.

(Looking for something more advanced? Seasoned options speculators can check out a new sister column, Advanced Options.)

Though fundamentally similar to standard options, LEAPS have a longer life span, with expiration dates set as far out as three years in the future. At any given time, an investor can purchase LEAPS that expire in the January that is two or three years away.

Similar to equity options, each LEAPS contract represents 100 shares of the underlying stock. Meanwhile, there are also index LEAPS, which allow investors to invest in – or hedge against – select industry sectors or the stock market in general. These longer-dated options generally represent about 10% of all listed options, and are traded just like regular calls and puts.

Why trade LEAPS? Because they last longer than other options, LEAPS are considered to be less risky. The price of the stock or index has much longer to perform as expected, so time decay - which is the enemy of the options buyer – affects these options at a slower pace. As a result, LEAPS can offer traders more peace of mind than conventional, shorter-dated options.

Plus, LEAPS offer traders an appealing alternative to owning shares of the stock outright. Investors put fewer dollars at risk by purchasing these options instead of stock, but can still benefit from the longer-term movement in the underlying share price. In addition, if the shares of the underlying security rise above the strike price of the LEAPS, the buyer could exercise the option, thus purchasing the shares at a discount to the current market value.

Furthermore, LEAPS have high deltas, meaning they behave much like the underlying stock, but with less original cash outlay. These higher deltas ensure better leverage with the underlying position, since the closer an option's delta is to 1.0, the closer it will move in direct parity with the stock.

For example, let's say that Ivan Q. Investor has his eye on Company XYZ, and thinks the stock's long-term future looks promising. The security is currently trading near $100, but Ivan doesn't want to pay $10,000 to control 100 shares. As a cheaper alternative, Ivan can purchase an in-the-money January 80 2010 call LEAPS on XYZ for about $25, or $2,500 per contract ($25 x 100 shares), saving him an impressive $7,500.

Since the LEAPS call is already 20 points in the money (making its intrinsic value 20), let's say it boasts a delta of 0.80. Simply put, for every single point the shares of XYZ gain, the LEAPS option should theoretically gain 0.8 point in value. Thus, other factors being equal, if XYZ rallies 10% from $100 to $110 within a relatively small time frame, the option price should go from $25 to $33 – an 8% move.

Now, let's say that by January 2010, the shares of XYZ have doubled to $200. By purchasing 100 shares of the stock outright, Ivan would have realized a 100% gain of $10,000. On the other hand, the LEAPS call would have an intrinsic value of 120 (200 stock price minus 80 strike price), which translates to a net profit of 100 (120 minus original intrinsic value of 20), or $10,000, quadrupling his original investment of only $2,500.

On the other hand, let's say that by January 2010, the shares of XYZ fell 50% to $50. By purchasing 100 shares of the stock outright, Ivan would have realized a loss of 50%, or $5,000. By purchasing a LEAPS option, however, Ivan's total loss was limited to the initial premium paid, which was only $2,500. In fact, no matter how low the stock falls, Ivan's maximum loss is limited to the initial cash outlay of $2,500.

However, keep in mind that LEAPS don't come without disadvantages, too. For one, unlike stock positions, LEAPS do not pay dividends. In addition, not all stocks have available LEAPS positions. Plus, the leverage factor enjoyed by LEAPS isn't as great as with short-term options. As such, the reward for playing near-term options is greater, since the additional risk from time decay is greater. On that note, because of their time value, LEAPS are generally more expensive than shorter-dated options.

To sign up today for a free subscription to "Bernie Schaeffer's SENTIMENT, smart options for today's investor," a new quarterly magazine devoted to the subject of options trading, click here. Sentiment's inaugural edition includes a cover story by Bernie -- "Are We There Yet?" -- that arms readers with some new tools for gauging a market bottom. Each issue of SENTIMENT is jam- packed with critical resources and information to help you trade in today's volatile market.