LEAPS

Since their introduction in 1990, Long-term Equity AnticiPation Securities, colloquially referred to as "LEAPS," have become an increasingly popular investment choice for the options investor. These options are either calls or puts with expiration dates up to 2-1/2 years in the future. Like standard equity options, each LEAPS contract represents 100 shares of the underlying security. LEAPS symbols typically consist of the equity symbol with the first letter modified by either the letters L, V, W, or Z. For example, LEAPS option roots on company XYZ might appear as WXY for 2002 expiration or VXY for expiration in 2003. This is not completely consistent, however, as there are occasional conflicts with pre-existing symbols.

LEAPS can be an ideal investment medium for the option trader who expects significant long-term growth in an underlying stock but who does not want to make the substantial capital outlay required for entering a long-term position in the stock. With expiration dates set months or even years in the future, time decay occurs very slowly for LEAPS, so buying LEAPS is an effective way to benefit from a stock's price movement without incurring the risk associated with an outright stock purchase.

The graph below illustrates how the time decay of an option is nonlinear. This means as the option approaches expiration, the time premium erodes more quickly compared to when the option has substantial life left.

Note how the steep time decay curve slopes for an option purchased with nine months until expiration (right of the yellow line) as compared to slope of the LEAPS option with 30 months until expiration. Also, consider the time decay for an option with just three months until expiration and the advantages of the extended life of LEAPS become quite apparent.

There is, however, a potential drawback to buying LEAPS instead of stock: LEAPS don't pay dividends. This may be a shortcoming if the stock you're interested in consistently pays out significant dividends, but companies that distribute large dividends are becoming more and more rare. Today, many businesses are limiting dividend payouts in favor of stock buybacks, or they're reinvesting the money in the company. Therefore, any disadvantage associated with giving up a dividend is likely to be minimal, and almost certainly less meaningful than it would have been just a few years ago.

LEAPS are excellent option strategies that find the happy medium between aggressive, short-term option trading and an outright purchase of the stock. It is much more profitable to use the short-term trading strategies if a stock is expected to move soon. If, however, the time horizon calls for a longer holding period and you want a leveraged way to play a stock without committing a lot of money, LEAPS may offer the most profitable strategy.

As an example of a LEAPS versus stock situation, let's say that you believe company ABC will ultimately fight its way out of its current slump to reassert itself as a technology leader. However, you're not sure of when this will happen, and buying the stock now (currently at about $50) could result in a major dollar loss if the shares continue to slide.

Rather than committing $5,000 for 100 shares of stock, you could purchase an in-the-money January 2003 40 call LEAPS for about $20, or $2,000 per contract. This purchase allows you to control the same number of ABC shares (100), but at a much reduced cost. The remaining $3,000 that you would have spent on the stock can be safely set aside in a money market account, protected against any downside risk should the stock decline. Note that the option is intrinsically worth 10 points (50 stock price minus 40 strike price). The remaining 10 points in time value represent the cost of "leasing" the stock's price movement until January 2003.

Because this LEAPS call is 10 points in the money, it has a rather high delta value of 0.80. This means that the option will behave very much like the stock by incorporating 80 percent of the stock's movement into the option price. Thus, other factors being equal, if the stock increases from 50 to 60 in a relatively quick time frame (say one or two months, a very reasonable assumption for a tech stock), the option will gain 80 percent of that move, or eight points from 20 to 28, a 40-percent advance versus the 20-percent gain in the stock.

Now let's look at how the stock and option positions would play out at various stock prices.

Suppose ABC doubles to 100 by January 2003 expiration. (This is not an unreasonable expectation given the stock's volatility and the fact that it traded above 80 earlier this year.) Stock buyers will realize a gain of $5,000. On the other hand, the LEAPS call will have an intrinsic value of 60 (100 stock price minus 40 strike price), which translates into a net profit of 40 (60 minus 20), or $4,000, a return of 200 percent. While the option return is 80 percent of the stock return on a total-dollar basis, keep in mind that the dollars at risk for the option ($2,000) were far less than those for the stock ($5,000).

Now let's turn to the downside. Should the stock drop 50 percent to 25, the stock buyer would be down $2,500. The option buyer's dollar loss, however, is limited to the total premium paid, which in this example is $2,000. No matter how poorly the stock performs, the option loss is capped at $2,000. In fact, at any stock price below 30, the stock position will lose more in dollars than the option position.

Note from the table that as the stock gains ground, the stock position will always outgain the option position on a dollar basis by the amount of the option's time value. This difference is the cost paid in the form of time premium to rent the option through January 2003 expiration.