LEAPS - A Simpler Explanation

[caption id="" align="alignright" width="276" caption="Image via Wikipedia"][/caption]

LEAPS can provide a more efficient use of one's investment dollars, while significantly enhancing profit potential.

Options are contracts to buy or sell stock. 

For an explanation of what option contracts are, suppose you wish to buy a house.  Today's real estate market has declined considerably from the highs of two years ago, and prices have stabilized, and in fact are beginning to increase in certain regions.  But at the same time, many homeowners just want out of their mortgages, and have decided to put their house on the market.  You've been looking around for some time, and finally the house of your dreams has come on the market, at a very good price of $200,000.00.  You are thrilled, and very much want to buy it.  However, before committing yourself to a new mortgage, you must first consult with a few family members and get your own finances in order.  Since you love the house, and do not want to let it go, you approach the seller and offer to buy his house at the asking price, but with the proviso that he hold off on closing for 6 months.  For that consideration, you offer him $20,000 as a nonrefundable deposit.  What you have done is secure the purchase price of the house at $200,000, and have also committed yourself to buy it within 6 months for the asking price of $200,000 (less your $20,000 deposit).  If you walk away, change your mind for any reason, you forfeit the $20,000.  On the other hand, if the market somehow rallies significantly and the house of your dreams is now worth $250,000, the seller has committed himself to sell you the house for $200,000.  That was the contract (known in real estate terms as a purchase option).  Why would you give someone $20,000 to hold a house for 6 months?  Because you, too, think the housing market is about to explode, and that depressed prices have gone on long enough, and want to tie up the house at today's price.  The seller, for his part, wants to secure his $200,000, and does not want to risk the market going down some more.  He got $20,000 which is his to keep if you walk away, and if you do complete the transaction, he is happy with the $200,000.  Of course, he is out of luck if the market explodes - he is obligated to sell you his house for the agreed-upon $200,000.

This is an "option," a choice, if you will.  It is your choice to buy or sell; and for that choice, you pay a premium if you are a buyer of such choice.

LEAPS are simply long-term options.  Since options are proxy instruments for stocks, they are priced in various increments.  If you buy stock, you own the company's shares, and are not subject to an expiration.  But just as in the real estate example above, where you bought a 6-month contract to buy the house for $200,000 and paid a premium of $20,000 (10%), stock options are essentially the same thing.  For example, take stock XYZ (hypothetical).  It sports a price of $584. You firmly believe the fundamentals of the company, and in fact, have been chomping at the bit to buy that stock, but didn't want to pay $584 for it.  Now, the stock has come down a bit to $520, but even at $520, buying 100 shares would set you back $52,000.  That is a very large amount of money.  What you could do instead is buy an option to buy the stock.  An option to buy is called a CALL option (and an option to sell is called a PUT option).  If you are sure you want to buy XYZ and are happy with its current price of $520, you may buy a 6-month option with a strike of $500.  The premium you would pay would be around $30 or $3000 for 1 contract (options are denominated in contracts with each contract controlling 100 shares).  So instead of spending $52,000, you spend a fraction of that amount ($3000) but are controlling the RIGHT to BUY XYZ for $500. 

Please note in the above example, the current price of XYZ is $520.  Your CALL option is $30 and the strike price is $500.  That means that $20 of the $30 premium is intrinsic value.  Intrinsic value refers to the amount of the underlying stock price that is currently traded for; it is the difference between the current market price of the stock and the strike price.  The difference of $10 is called time value, and it is the "price" for the 6 months of waiting for the stock to move.  Why would there be a time value in a call option?  Because the market is assuming a rise in the underlying stock.  Not all stocks have the same time value.  The more volatile a stock; the larger the time value.  Also, the deeper in the money the strike price is, the less time value is factored into the premium.  There are many schools of thought on how to buy (and sell) options.  You could pay much less than the $30 in this example by buying, say, a $550 strike CALL option, which might cost you a mere $10 (or $1000 for the 100-share contract).  It is much less, and for the $3000 you might think that you should buy 3 such contracts.  But the danger in such a technique is that you are making a bet that the stock would rise to $560 within the next 6 months.  Why $560 and not $550 as the strike price?  Because in order to recoup the $10 you've just spent, the underlying stock would need to move $10 above your strike price of $550.  With the market price of the stock currently at $520, it would be difficult for the stock to rise by $40 within 6 months, and you stand a good chance of losing your investment of $10.  A strike price of $500 is said to be deep in the money, because it is a full $20 within the current market price of the stock, and your $30 premium encompasses some of the real meat of the stock, not just the intangible time aspect.  It may be more costly in terms of dollars, but the chances of winning are greater, as the stock doesn't have to move that far for you to make your money back - and gain as the stock advances from your break even.  In the $500-strike example with the $30 premium, all the stock has to do is rise by $10 for you to break even.  In other words, the stock can rise to a mere $530, and you could sell your option if you no longer felt positive about that move, and redeploy your funds elsewhere.  Once the XYZ stock moved to $530, your option would then rise dollar for dollar in tandem with the stock, because it would be entirely in the money (intrinsic value).

Now, why LEAPS (long-term options)?  The longer the time to expiration, the less volatility.  In other words, the less the underlying stock moves to the rhythm of market news - the more stability you have to wait and see and let things "cook." You have perspective.  For that privilege, you usually have to pay more in dollar terms, but such expenditures now represent more of an investment than their shorter-term counterparts.