What are LEAPS Options?

Many investors are familiar with the term stock options, but relatively few understand what they are and how they work. Stock options are simply contracts that give buyers the right, but not obligation, to buy or sell an underlying stock at a specific price on or before a certain date. LEAPS – or long-term equity anticipation securities – are simply long-term stock options.

Still confused? The concept of an option can be found in the real estate market. Say, for example, that you find a house that you want to purchase. Unfortunately, you won’t have the cash you need to buy it for another two months. After negotiating with the owner, you propose a deal that gives you the right to buy the house in two months for 250,000 dollars. In return, the owner requires that you pay 2,500 dollars for the option.

In the stock market, all options follow a standard format and contain the following elements:

• Symbol – Like a stock, options have a series of letters associated with them. And yes, there is logic to these numbers, but it’s too complicated for this section!
• Strike Price – The price at which the option can be exercised is known as the option’s strike price. Options with strike prices trading above the current market price are said to be out-of-the-money while options with strike prices trading below the current market price are said to be in-the-money.
• Premium – The price to purchase the option itself is known as the option’s premium. The amount of premium paid depends on the stock’s volatility and the time until expiration.
• Expiration Date – The time at which an option expires is known as the options expiration date. LEAPS have expiration dates set one or more years into the future.

There are two basic types of stock options:

1. Call Options – A call option gives the holder the right to buy a stock at a certain price within a specific period of time. Calls are bets on the stock price increasing as you are always looking to buy the stock.
2. Put Options – A put option gives the holder the right to sell a stock at a certain price within a specific period of time. Puts are bets that a stock will fall as you are looking to sell the stock.

Every time someone purchases a stock option, there has to be someone on the other end selling too. These investors that are selling - or writing in option’s lingo – stock options. As a result, there are two additional types of transactions:

1. Writing Calls – Investors that write a call option are obligated to sell their shares at a set price on or before a set time at the option buyer’s discretion.
2. Writing Puts – Investors that write a put option are obligated to buy shares of a stock at a set price on or before a set time at the option buyer’s discretion.

How Options Work

Let’s suppose that you believe Widget Inc. is undervalued because the market fails to take into account a new product that will change the way people get coffee in the morning. You know that this product is coming out within the next three months, but you don’t want to invest the money until it hits store shelves. So, you decide to buy an option on the stock.

Widget Inc., ticker symbol WDGT, is trading at 50 dollars per share right now. You look and there is a call option that gives you the right to buy WDGT for 60 dollars over the next three months. The cost to buy this option is 2 dollars and 50 cents per contract. In options lingo, the option has a strike price of 60 dollars, an expiration date set three months out in the future, and a premium of 2 dollars and 50 cents.

You decide to buy the right to 100 shares for 250 dollars total, which is far less than the 5 thousand dollars needed to buy 100 shares of WDGT. The result is a situation where you can make a higher return on investment since you are spending less for the same upside, assuming that the price moves above the strike price.

Scenario 1

Widget Inc. releases their new steering wheel and it is a huge success. The company’s stock rises to 100 dollars per share during the next three months. Now, you have two options:

1. Use the Option – Using, or exercising, the call option means purchasing 100 shares at 60 dollars per share. You can then hold on to the shares or immediately sell them for 100 dollars on the open market.
2. Sell the Option – You can also sell the call option itself to another investor that will turn around and exercise it. The premium on the option increases with the price of the stock when the expiration date draws closer. So, your option will now be worth around 40 dollars per contract. This is the most common thing to do as you don’t have to spend the 6 thousand dollars to buy the stock or pay the commissions associated.

Scenario 2

Widget Inc. releases their new steering wheel, but it’s a flop and nobody buys the product. As a result, the stock drops to 10 dollars per share. Since your options are at 60 dollars per share, it does not make sense to use, or exercise, them to buy stock since you’d be immediately losing money. So, you just let the option expire worthless. In this case, you have saved money since the loss holding the stock itself is greater (-4 thousand dollars) than the 250 dollar loss buying the options.

Scenario 3

Widget Inc. releases their new steering wheel and nothing happens as expectations were already reasonable. As a result, the stock stays at 50 dollars per share. Since your options are at 60 dollars per share, it does not make sense to use, or exercise, them to buy stock since you’d be immediately losing money. Additionally, you have lost money since the 250 dollar cost of the option is greater than the loss of holding the shares.

Why LEAPS?

Investors are notorious for looking at the past through rose-colored glasses. Those who were not in the market during a bullish move will regret not buying a stock while those who were in the market during a bearish move will regret not waiting to buy. Unfortunately, making this is a necessary decision when investing… or is it?

Purchasing LEAPS calls can give long-term investors an effective way to hedge a cash position by providing participation in the market with limited risk. LEAPS provide a way to get the best of both worlds without making the big decision!

Benefits of Using LEAPS

There are several advantages associated with using LEAPS as opposed to purchasing the underlying stock:

1. Move Leverage – LEAPS can help you make more money with less out-of-pocket cost.
2. Less Capital at Risk – LEAPS can help you establish the same position that you would otherwise with a lot less dollars at risk.
3. More Diversification – LEAPS are cheaper than stock, so you can buy more of them. More stocks in a portfolio means greater diversification for the investor.

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