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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
Diversification
Hedge
What's the Downside?
Stock Versus LEAPS®
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. How LEAPS® Work 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.
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:
However, LEAPS® differ from shorter-term options in several ways including availability, pricing, time erosion vs. delta effect, symbols and strategies. 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, get a stock/index quote and choose 'Option chains' to see a list of all options for that specific security. 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. LEAPS® Pricing 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 1/2 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. 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. Motorola (MOT)
This feature makes it easy to distinguish a longer-term option from a shorter-term option in data listings. Time Erosion vs. Delta Effect 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:
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. 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
Buy LEAPS® Calls 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 50? and a ZYX LEAPS® call option, with a two-year expiration and a strike price of 50, is trading for a premium of 8? 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 58?, the total of the option premium (8?) 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 58?. The following are possible outcomes of this strategy at expiration. Stock above the break-even point
Stock below the strike price
Stock between the strike price and the break-even point
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. Buy 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 42? is selling for 3? 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
Stock below the strike price
Stock between the strike price and the break-even point
Sell LEAPS® Covered Calls 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. Investors should be aware of the risks involved in a covered call strategy. Call 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 39?, and a ZYX LEAPS® call option with a two-year expiration and a strike price of 45 is trading at 3?. An investor owns 500 shares of ZYX at $39? per share and sells five of ZYX LEAPS® calls with a strike price of 45 at 3? 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 36? (the stock price of 39? less the premium received of 3?). This represents downside protection of 3? points. A loss will be incurred if ZYX declines to below 36?. Possible outcomes of this strategy at expiration are as follows. Stock above the strike price
Stock below the break-even point
Stock between the strike price and the break-even point
LEAPS® Contract Specifications Unit of Trade: Generally 100 shares of stock per unadjusted contract. Premium (Price) Quotations: Stated in points and fractions; one point equals $100. The minimum price change for series trading below 3 is .05 ($5) and for all other series is .10 ($10) per contract. Exercise: Equity LEAPS® are American-style options. The option may be exercised prior to the expiration date. Exercise Settlement: A holder that tenders an exercise notice on any business day will receive delivery of the underlying stock on the fifth business day following the date of exercise. The exercise settlement price equals the strike price multiplied by 100 (multiplier) for unadjusted series. Expiration Cycle: Equity LEAPS® expire in January of each year. Expiration Date: Expiration occurs on the Saturday following the third Friday of the expiration month. Position Limits: LEAPS® positions are aggregated with other options with the same underlying asset. Limits vary according to the number of outstanding shares and trading volume. Hedge exemptions may be available. Contact exchanges for details. Trading System: Market Maker/Designated Primary Market Maker/Lead Market Maker/Specialist/Registered Option Trader (depending on the exchange). Trading Hours:
Important Note: Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. |