LEAPS

Long-Term Equity AnticiPation Securities, or LEAPS, are equity or index options whose expiry date is at least 9 months into the future and can be as long as 39 months out. In many ways they are just like other exchange traded options:

1. You can buy or sell puts and calls.

2. Buying or selling a LEAPS put or call carries the same rights and/or obligations as short term options.

3. Each LEAPS contract  covers 100 shares.

4. The exercise and assignment procedures are the same.

1. LEAPS are not automatically available on all optionable equities and indexes. Rather, they become available due to demand from the various market participants.

2. Initially, LEAPS are listed with only three strike prices - at-the-money, in-the-money and out-of-the-money. As the underlying moves, other strikes may then be added. When the strike price is between $5 and $25 on equity options, the interval is 2.5 points. Between $25 and $200 it is 5 points and it is 10 points on strikes over $200. For most Index LEAPS the interval is usually 5 or 10 points.

3. All LEAPS have only one expiration month, which is January. As they draw to within 9 months of their expiration, they are rolled over into ordinary shorter term options and are replaced by new LEAPS options.

4. The effect of time decay on the price of LEAPS is different from its effect on shorter term options. Because LEAPS can exist up to 39 months out from expiration, their loss of value due to time decay is less than it is in options that are closer to expiration.

5. Most equity LEAPS are exercised according to the American style, in that they can be exercised on any business day before the expiration date. On the other hand, most Index LEAPS are European in their exercise style - they can only be exercised on the last business day before expiration. All short term options are American style.

Despite these differences, the same strategies used with shorter term options can also be used with LEAPS - buying/selling puts/calls, spreads...etc. Probably one of the most popular, however, is the Covered Call. It is constructed in the same way as a traditional Covered call, except that the LEAPS option is substituted for the stock of the underlying.

As an example, IBM is trading at $88.43. The $90.00 front-month option is selling for $1.80. To sell five $90.00 call contracts would require the purchase of 500 IBM shares at a cost of $44,215. You would then collect $900 in premium for a return of 2.04% (assuming no margin were used).

By substituting in-the-money LEAPS for the IBM stock, the situation changes quite dramatically. The two year out $75.00 LEAPS are selling for $21.00. Five of these contracts would cost you $10,500. By selling the same front-month $90.00 options you again collect $900 in premium. This time, however, your return is 8.57%!

The only other factor effecting this comparison is dividends - as the owner of the stock you would collect them, but as the owner of LEAPS options you would not.

In-the-money LEAPS are used because their delta is 1.00 (delta measures the rate of change in the price of the option compared with a one-unit change in the price of the underlying.) Consequently, the price fluctuations of the LEAPS option would mimic the changes in the price of the underlying stock.

This strategy also provides greater downside protection than the traditional Covered Call:

1. If the price of the stock dropped to zero, you would lose your entire investment of $44,215. By holding the LEAPS option, you can never lose more than your initial investment, which is only $10,500.

2. If the price of the stock dropped to $70.00, the LEAPS option would now be out-of-the-money. It would therefore have no intrinsic value, only time value. And while each share would have lost $18.43, the loss on the LEAPS option would be lower due to the amount of time value it still had.

3. Such a large drop in the underlying's share price would have the opposite effect the LEAPS' implied volatility. Implied volatility is one of the factors which effect an option's price (the others being the underlying's price, the strike price, the time to expiration and interest rates). As implied volatility rises, it would put upward pressure on the price of the LEAPS, to some degree compensating for the loss of intrinsic value.

The owner of the underlying share would enjoy no such compensating effect. Accordingly, there are a number of reasons why LEAPS based Covered Call advisory services, as opposed to traditional stock based ones, should be considered.