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LEAPS Option

LEAPS option offer investors another way to make money and beat the stock market. Most people think of options as relatively short term investment vehicles lasting just a few months. There are options that can be traded with up to a three-year term. Long-term Equity AnticiPation Securities (LEAPS) are option contracts that allow investors to take positions with much longer expiration dates, up to three years, though 18 months is more normal. LEAP options are available for a growing number of equities and indexes. The Chicago Board Options Exchange (CBOE) maintains a symbol listing of all the CBOE Equity LEAPS and Index LEAPS. Leaning to invest with LEAPS options gives you another tool to build wealth and beat the market.

Many stock and options investors use LEAPS to in their investing strategies to enhance their returns and lower risk. In this article, we will cover the benefits and risks of LEAPS and the factors that affect the option premium. This is the first part of a series of articles on LEAPS and some of the strategies that investors and traders can employ.

Benefits of LEAPS Option

LEAPS have many of the same benefits of short-term options. Due to the longer-term nature of LEAPS, they offer unique benefits to investors that are not available through normal shorter term options. The biggest advantage of a LEAP is its low cost compared to the cost of the stock. When you are investing in a LEAP, that is how you should think -- its cost relative to the cost of the stock, not relative to the cost of short-term options. Some key benefits are:

Risks of LEAPS Option

Like any investment, LEAPS come with their own set of risks.

I encourage anyone who is interested in using LEAPS as well as regular options to read The Options Clearing Corporation Characteristics and Risks of option Disclosure Document.

Let's quickly compare how purchasing LEAPS instead of stock can be beneficial for investors.

Suppose an investor with a $10,000 portfolio purchased 100 shares of XYZ, which were trading at $50 per share at the time the trade was placed. The investor has the following choices: purchase the stock outright, utilize 50% margin at a rate of 9% to purchase on margin or purchase a LEAPS call expiring 18 months from now with a strike price of $40 paying an option premium of $12.25. Finally, let’s assume the stock rises 20% to $60 per share after one year.

Using Stock Using Stock w/Margin Using LEAPS
Cash Down $5,000 $2,500 $1,325
Borrow $0 $2,500 $0
Carry Cost $0 $225 (9% over 1 year) $220 (time premium)
Less Dividends -$50 -$50 $0
Net Carry Cost -$50 $175 $220
Risk $5,000 $5,000 $1,325
Net Profit 21% 33% 559%

As you can see, the LEAPS options significantly out performed the other alternatives. This is an example of how LEAPS options provide you a way to use leverage without having to pay the cost of borrowing money on margin. At the money, LEAPS call options initially have higher leverage and volatility. Minor changes in the market price/span of the underlying security can result in high percentage changes in the price of the option and the value may fluctuate by 5% on a typical day. You need to be ready for this volatility if you are considering LEAPS.

Factors Affecting LEAPS Option Premium

There are four major factors that can affect the option premium. Known as the Greeks, these factors are measures that can be examined to get a better understanding f the risk an option investor, including LEAPS, should understand. The table below provides a brief overview of the major Greeks. There are other Greeks, but these are the most important ones.

Delta Gamma Theta Vega
Measures Impact of a Change in the Price of Underlying Measures the Rate of Change of Delta Measures Impact of a Change in Time Remaining Measures Impact of a Change in Volatility

Delta is a measure of the change in an option's price (premium of an option) resulting from a change in the underlying security (i.e. stock) or commodity (i.e. futures contract). The value of delta ranges from 0 to 1.000 for calls and -1.000 to 0 for puts. Calls have a positive relationship to the price of the underlying security and puts have a negative relationship.

An at-the- money option with a delta value of 0.500 means the premium of the option will rise or fall by half a point for every one point move up or down in the underlying security. As the option gets further in the money, Delta will move up, approaching 1.000 if it is a call and -1.000 if it is a Put. This only occurs when there is very little time value on the option, i.e. the option is about to expire.

LEAPS option investors should look at the delta of the options they are considering to get an understanding of the potential movement of the option relative to the underlying security. Delta will change as the price of the underlying security changes and as time goes by.

Delta tends to increase, as you get closer to the expiration date for near or at the money options. Delta will also change with changes in the volatility of the underlying security, called implies volatility.

Gamma, also know as the first derivative of Delta for you math majors, measures the rate of change in Delta. Gamma is highest for at or near the money options, meaning Delta will change the most. It is smallest for deep out of the money and deep in the money options, meaning Delta will not change as fast in this situation.

An investor in LEAPS should know what the likely change in Delta is before making a commitment. Just as Delta changes with changes in the underlying security, so does Gamma.

Theta measures the rate of decline of the time-premium as time goes by. It tells you the amount the option will fall in price with each passing day. LEAPS have very small Thetas since they have a long expiration period and do not lose very much time-premium with each passing day. Options with one to two months till expiration will have much higher Thetas. This is why writing covered calls is such a useful strategy.

Theta is normally high for options with high-implied volatility. For at the money options, theta is typically the highest.

Vega measures the risk of changes in implied volatility. Holders of options often benefit from a fall in implied volatility and usually are hurt when implied volatility rises. Sellers of options experience just the opposite.

Vega will normally increase with rapid moves in the underlying security, especially if there is a quick drop in the price of the shares. Vega can change even without a change in the price of the underlying security, just due to change in the expected level of volatility. Further Vega tends to fall, as the option gets closer to the expiration date.

Knowing these factors will help investors to employ various options strategies that will be discussed in later articles.

The Bottom Line

LEAPS offer investors another way to participate in the rise and fall of a stock, ETF or commodity. They are characterized by lower capital requirements and no need to use margin to increase returns. The operate just like shorter term options only they have a very slow time decay factor (Theta) which makes them an interesting alternative to buying or shorting the underlying security.

They also offer investors another way to use the various option strategies that are available, especially those that assume purchase of the underlying security.


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