The Advantages of LEAPS
— “Calling the Trend” Column, by George Leong, B.Comm.
As we shortly close off 2009 and move into 2010, we will be capping off the best year of stock market gains since 2003. However, after the performance in 2009, there is expected to be some hesitancy heading into 2010.
A way you can reduce the overall market risk is via the use of options. Though most option strategies tend to be a short-term in nature, there is an option strategy that is straightforward and makes sense for the long-term investor who wants to play the longer term on a certain budget.
Referred to as “Long Term Equity Anticipation Securities” (LEAPS), these are simply longer-term options with an expiry ranging from a minimum of nine months to a maximum of three years from the time of purchase. They can be purchased as calls or puts; however, I will focus on calls for the purpose of this article.
First traded on the Chicago Board of Exchange (CBOE) in 1990, LEAPS have become quite popular as an investment strategy.
LEAPS were originally developed to allow the more conservative investor a longer timeframe for carrying out their options strategy. And during the 19 years since surfacing, the use of LEAPS has become an integral part of portfolio strategies involving stocks, indices and currencies for both the institutional and retail investor.
What are the advantages?
The cash outlay for LEAPS is relatively cheap versus the capital that’s required for buying the underlying stock.
For example, an investor who is bullish on the long-term outlook of Intel Corp. (NASDAQ/INTC) is considering buying 1,000 shares, which, at the price of $19.63 as of December 21, would entail a cash outlay of $19,630.
For the small investor, the cash requirement is unrealistic. But, by purchasing LEAPS, he or she could buy the right, but not the obligation, to purchase 1,000 shares of Intel by buying 10 contracts of the Intel January 2012 $20 LEAPS. The cost of the transaction (excluding commissions) is $3,050 (10 contracts x 100 shares x $3.05 premium).
The 10 LEAPS entitle the investor to buy Intel at the $20.00 strike price at any time prior to the January 20, 2012 expiry date. If the shares of Intel do surge over the next several years as expected, then the strategy would prove beneficial.
Let’s take a look. If the shares of Intel increase to $30.00 by January 2012, the investor would generate pre-commission profits of $6,950 ($30.00 – $20.00 – $3.05 x 10 contracts x 100 shares). The breakeven price for the Intel LEAPS is $23.05 ($20.00 + $3.05 premium).
Also note that the investor could alternatively exercise the LEAPS, which would allow for the purchasing of 1,000 shares of Intel at the $85.00 strike price. This alternative would be chosen if the investor remained bullish on Intel, while also wanting to hold the stock in their portfolio.
Due to their long-term nature, LEAPS afford investors more time for their option investment to pan out. An investor bullish on the long-term outlook for a stock may want to consider LEAPS.
For instance, take a look at U.S. PC-maker Dell Inc. (NASDAQ/DELL). In terms of stock performance, Dell has been one of the best performing stocks in recent years. Since its IPO in 1991, Dell has recorded seven stock splits.
In that period, the return on Dell shares has easily outperformed the S&P 500 by a wide margin. By using LEAPS, an investor would have made some significant gains on Dell.
The same could be said for other stocks, including Microsoft Corporation (NASDAQ/MSFT) and Cisco Systems Inc. (NASDAQ/CSCO).
3. Less Volatility
The price of an option is comprised of the intrinsic value and the time value component. Intrinsic value refers to the relation of the strike price to the market price of the stock. The time value portion of the price relates to the length of the option contract.
Without going into a theoretical explanation of time value, the only thing you need to understand is that LEAPS tend to erode slower than traditional short-term options. In other words, the price of LEAPS decline at a slower rate and is less volatile than shorter-term options.
For long-term investors, LEAPS can represent a viable investment.
LEAPS are widely available on U.S. stocks. For U.S.-listed LEAPS, refer to www.cbot.com.
Because options are inherently risky, I recommend speaking with an options specialist before considering a strategy.