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    Offbeat Offerings: LEAPS

    by Cara Scatizzi

    Offbeat Offerings: LEAPS Splash image

    Long-Term Equity Anticipation Securities, or LEAPS, are publicly traded options contracts that have expiration dates longer than one year and up to three years.

    LEAPS are structured like short-term options, but the longer expiration dates allow investors to use a longer-term approach without having to roll over several short-term options contracts. They are available on both individual stocks, as well as many stock indexes.

    How It Works

    LEAPS were introduced in 1990 by the Chicago Board Options Exchange (CBOE). According to the CBOE, LEAPS are available on approximately 450 equities and 10 indexes.

    A basic equity option is a contract sold by an option writer (the seller) to an option holder (the buyer). The option buyer receives the right, but not the obligation, to buy (a “call option”) or sell (a “put option”) a particular security or index at an agreed-upon price (the strike price) until a specific date (the exercise date).

    For example, let’s say you buy a call option on IBM stock with a strike price of $125 and an exercise date of a year from now. That means that for any time up until the exercise date, you could exercise your option to buy the stock at $125, even if the actual price of IBM goes higher than $125. Conversely, if you buy a put option on IBM stock with a strike price of $125 and an exercise date one year from now, you could exercise your option to sell the stock for $125, even if the price of IBM falls below $125.

    The price of an option contract is called a premium, which the buyer pays to the option writer (seller) for the rights conveyed by the contract. Premiums are determined in the marketplace, and are a function of the current stock (or index) price, the strike price, the time to expiration, and the volatility of the underlying stock.

    In general, premiums for LEAPs are higher than for standard options for the same stock because of the longer-term expiration date, allowing more time for the underlying asset to change in price in a way that would result in a gain for the option holder.

    Types

    There are two types of LEAPS: equity and index.

    Equity LEAPS are longer-term options on common stock or American depositary receipts (ADRs); the underlying asset in an equity LEAP is the shares in a company.

    Index LEAPS are longer-term options on a specified index. However, the underlying asset covered by an index option is not shares in a company, but rather an underlying dollar value equal to the index level. The amount of cash received upon exercise or at expiration depends on the settlement value of the index in comparison to the strike price of the index option. In general, the value of an index call will increase as the price level of its underlying index rises. Alternatively, the value of an index put increases as the price level of its underlying index decreases.

    How to Trade

    Options, including LEAPS, are sold through broker-dealers or on-line trading networks.

    Before a LEAPS option is listed, the listing exchange ensures 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 for every stock that has options traded on it.

    In order to determine if LEAPS are available on a stock that interests you, consult the Directory of Listed Options at the Options Industry Council Web site (under the Key Links heading). LEAPS account for approximately 10% of all options listed.

    Investor Suitability

    LEAPS can be used in a number of ways, including:

    • Purchasing calls can provide long-term stock market investors an opportunity to benefit from gains in the underlying stock without having to commit as much capital as would be the case when making an outright stock purchase;

    • Purchasing puts can provide a hedge against substantial declines in the underlying stock;

    • The purchase of index LEAPS lets you trade, hedge or invest in the entire stock market or select industry sectors for a time measured in years.

    There are also many strategies that involve the selling (writing) of LEAPS, but these strategies can be much riskier.

    The risk of using LEAPS varies depending upon the strategy followed. If you are a LEAPS buyer, your risk is limited to the price you paid for the position. However, if you are an uncovered seller (you do not own the underlying shares), there is unlimited risk (for selling uncovered calls) or significant risk (for selling uncovered puts).

    LEAPS provide a longer timeframe than a standard option for a strategy to turn profitable. However, all options have an expiration date, and timing is a key consideration; an investor can make a correct call on the direction of a stock or index, and still lose if the option expires before the strategy plays out.

    Options and option strategies are complex and require a thorough understanding of how they work, trade, and the risks associated with the various strategies before they can be used effectively as part of an investment strategy.

    Tax Consequences

    Tax issues can be complex for options, including LEAPS. For example, the tax issues relating to the purchase of options differ from those relating to the selling (writing) of options.

    For simple option purchases (you buy a put or a call), in general:

    • If you sell a call or put before you exercise it, the difference between its cost and the amount you receive for it is either a long-term or short-term capital gain or loss, depending on how long you held it;

    • If the option expires, its cost is either a long-term or short-term capital loss, depending on your holding period, which ends on the expiration date;

    • If you exercise a call, add its cost to the basis of the stock you bought; if you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock.

    However, it is important to understand any tax implications when considering an options investment. For a complete discussion of the tax issues involving options, see IRS Publication 550.

    The Pros

    Ability to Hedge
    LEAPS puts provide investors with a means to hedge current stock holdings or even entire markets using LEAPS indexes if they fear potential price drops.

    Stock Alternative
    LEAPS offer investors an alternative to stock ownership, allowing them to benefit from rising stock prices while placing less capital at risk than is required to purchase stock. If the stock price rises to a level above the exercise price, the investor may exercise the option and purchase shares at a price below the current market price, or the investor may sell the LEAPS calls in the open market for a profit.

    The Cons

    Higher Risk, Especially for Some Strategies
    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 is leveraged—the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.

    If you are a LEAPS buyer, your risk is limited to the price you paid for the option. However, if you are an uncovered seller, there is unlimited risk (for calls), or significant risk (for puts). Risk varies depending upon the strategy followed, and it is important for an investor to fully understand the risk of each strategy.

    Limited Life
    Unlike common stock, which can be held indefinitely, every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument; an option investor must not only correctly pick the direction of the underlying stock, but also correctly select the timeframe when that movement will take place.

    Complex Product
    Options, including LEAPS, are complex investment instruments requiring considerable knowledge about options, options markets and options strategies.

    Additional Information

    Chicago Board of Options Exchange
    www.cboe.com/products/leaps.aspx
    The Chicago Board Options Exchange (CBOE) is an exchange that focuses on options contracts for individual equities, indexes and interest rates. The CBOE Web site offers information on all types of options, including LEAPS. An index LEAPS brochure can be downloaded in PDF format by choosing “Index Options” from the left side menu bar.

    The Options Industry Council
    www.optionseducation.org
    The Options Industry Council (OIC) was created to educate investors and their financial advisors about the benefits and risks of exchange-traded equity options. The OIC Web site offers considerable information and education on options, including LEAPs. The OIC also conducts seminars and webcasts throughout the year.


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