Take a Flying LEAP

Today I was going to post a recipe using long-term options, otherwise known as LEAPS, but in the middle of writing it up, I felt that a little background is needed first especially if the reader is unfamiliar with them. But LEAPS are worthy of discussion in their own right as they can be used as a substitute for owning (or shorting) stock. If you know LEAPS like the back of your hand, then move on. Today's discussion probably won't interest you. But if you're like many investors whose only concept of going long is to buy stock, then I highly suggest you read on for LEAPS can provide you with a cheaper way of participating in price movement, limit your downside risk, and magnify your returns. Do any of these sound intriguing?

What is a LEAP?
A LEAP is an acronym for a long-term option (Long-Term Equity Anticipation Securities). Of the universe of over three thousand optionable stocks, about a third of them offer long-term options. Most LEAPS have expiration dates set 1-3 years into the future, with January 2010 options currently being the furthest ones available. *

LEAP Calls versus Stocks
Like anything else, LEAPS have their good and bad points.
The Good
1. LEAP calls are much cheaper to own than stocks--some can be as low as 10% of a stock's face value. This means that if you're itching to buy a very expensive stock such as Google (currently trading around $570/share) but you can't afford the $57,000 required to buy a 100 shares, you might consider buying the January 2010 LEAP call at the 570 strike (denoted by 10Jan 570 call) which would cost about $117/contract. Since one contract represents 100 shares of stock, the total you would have to shell out is $11,700. That's over $45,000 in savings which (if you have the funds) you can use to make other purchases or put in an interest bearing account.
2. Because of the huge leverage that options offer, your profits will be magnified. Let's take an example. Today, an analyst upgraded Continental Airlines (CAL) with a price target of $22. Although he didn't specify when he expects the stock to reach that price, let's say that it will take about 18 months to do it which isn't unreasonable. You can purchase the stock today at the current price of about $13.50/share, or you can buy the 10Jan 12.5 call option for $4.50/contract. (Talk about a flying LEAP! (Flying...airlines...) Oh, stop groaning.) At options expiration, what will be the difference in returns? Had you just purchased the stock, your profit would be $8.50/share or 63% which is great. But if you had purchased the option, it would be worth $9.50/contract (the stock price at expiration minus the strike price). You'd have netted a total of $5/contract (the option value at expiration minus the initial cost of the option) which gives a total profit of $500/$450 x 100 = 111%. (Commission costs are not included in the calculations.) In other words, you would have doubled your profit with the added benefit of a reduced initial capital outlay.
3. The maximum risk of the LEAPS approach is limited to the cost of the option. In the above example, let's say that something untoward happens to CAL such as an accounting scandal which causes the stock to lose 90% of its value in a second. The owner of 100 shares of CAL stock just lost $1200, but the owner of the LEAP would have had her loss limited to the option's cost of $450.

The Bad
1. Options owners are not eligible for dividends nor do they have voting rights. LEAPS on high-dividend stocks are probably not the way to go unless you're using a put LEAP as a hedge.
2. The price of an option includes time premium, and it's the time premium which will erode the value of the option (assuming the stock price remains constant). As expiration approaches, time decay becomes especially pronounced which options holders should be aware of. If it looks like your stock isn't going anywhere for the three or so months before expiration, then selling your option while it still has some time value is the prudent thing to do.
3. Buying LEAP calls is a very bullish strategy. For you just to break even, the underlying stock must be greater than the strike price of the option plus the option's cost. In the example of CAL, the break-even point would be $13.50 + $4.50 = $18.00/share.
4. You can also lose money even if the price of the stock remains the same through a decrease in option volatility. In one sense, volatility is a measure of how “hot” a stock is. Higher volatility means that more people are interested in it. Buying an option with long-term expectations just after some exciting news has been released is usually not the best time. Wait a few days (or weeks) until the volatility has a chance to settle down.

Timing is Key
You can see that LEAPS offer definite advantages over buying stocks, but as we also saw, they're not without risk. In options especially, timing is everything. If you're bullish on a stock and can't wait to LEAP into it (sorry!), you're automatically putting yourself at a disadvantage by limiting your returns and increasing your risk. Wait until your stock pulls back to a support level before buying.

Getting the Best Price
How do you know if you're getting a good price on your LEAP? One way to know is to check out the current bid price against the theoretical price as computed by the Black-Scholes formula. (Actually, there are two pricing methods: one based on historical volatility and the other based on current implied volatility as given by the SIV. The second one usually gives a higher value.) Many brokerage firms provide this information in their options chains. If the bid price is greater than the Black-Scholes value, the option is considered to be over valued. Conversely, if the option is below it, then it's under valued. (You can use this method to compare options with the same strikes but with different expirations.)

Another way is to compare the chart of the stock with the chart of the option. Is the current price of the option greater than or less than its price on a day when the stock was at a comparable price? Trading at a higher value is an indication that the implied volatility has increased thus inflating the option price. Wait until the volatility stablizes.

The LEAP Put
If you're long-term bearish on a stock, then purchasing a LEAP put can be a useful substitute for shorting stock. The margin requirements will also probably be much less (check with your broker). The same points apply to puts as calls, but there is one difference: the return for a call is unlimited but the return for a put is capped since the price of the stock can't go below zero. Good candidates for LEAP puts are weak stocks in sinking sectors.

Summary
Now you know what a LEAP is and how it can enhance your investment returns, but if you still need more information, click on the Options links at the top of the page. Today is just a warm-up for next week's recipe, Calendar Call Cake. In upcoming blogs I'm also going to see if I can't find some tasty LEAP candidates for you to snack on so stay hungry!

*Note that LEAPS come with options roots that are different from the roots of their regular counterparts. About 6 months or so before their expiration, the LEAPS root will revert to the normal root. This is just a heads-up so you won't be confused when you open up your brokerage statement and see a strange looking option symbol on it.