Jan 25, 2013
Options are a contract between a buyer and seller, and can be classified as derivatives, where value is determined by an underlying investment. Most commonly, options use stocks as the underlying investment, but this is not always the case. It is possible to find options based upon indexes, commodities, and many other investment choices. There is a host of option alternatives for investors to choose from, including: "call", "put", and "LEAP" options.
Long-term Equity Anticipation, or LEAP options, are actually contracts which grant investors the right to buy or sell
stock at a fixed price - prior to the expiration date.
The buyer of a LEAP option is known as the holder whereas
the seller is referred to as the writer. As far as fulfilling the contract is concerned, it is the writer's responsibility to manage it if, and when, the holder of the LEAP option decides to exercise his/her right to purchase the offered stocks.
LEAP's are not all that different from other options, but there is one fundamental characteristic that sets them
apart: their expiration date is further out in the future. This is a big advantage for investors, as it tends to be easier to forecast long-term trends in stock prices. However, options remain a greater investment risk for the first time investor than simply buying the stock outright.
It is also true that LEAP's can provide great returns when things go as planned.
Assume that an investor was interested in buying Microsoft's stock which is currently trading at $25 a share. While undeniably, Microsoft is a quality stock with great potential; its stock price may never increase enough to justify risking a direct stock purchase. In such a case, the investor might decide to buy a LEAP option for the stock as follows: Microsoft August 30 call at $2.
This Microsoft Leap is a type of call option, which means that the investor has the right, but not the obligation, to purchase the stock at the strike price before the expiration date. In the above sample, the investor has purchased a LEAP involving Microsoft stock that will expire in August (LEAP's are generally written for 3 years). Options always expire on the first Saturday following the third Friday of the month of their expiration.
The strike price is $30, which means the investor is betting that the price of Microsoft stock will at least touch this amount on or before the expiration date. But if the stock were to be exactly at $30 on the day the investor decided to exercise the option, it would still amount to a net loss on the investment. There are two reasons for this: the call price and commission fees.
The call price amounts to the premium paid to purchase the LEAP.
On this transaction involving one Microsoft LEAP, the total premium comes to $200. Because options are
sold in 100-share blocks, the call price is multiplied by the 100 shares of stock.
Investors need to also be aware that the commissions charged for option transactions are higher than those assessed for stock transactions. While the commission fees vary from institution to institution, they tend to be around 25-30% higher than typical stock trades. For the purposes of our sample, assume the commissions were $30 to purchase the LEAP and $50 to exercise it.
Therefore, if the price of the Microsoft stock was at $38 at the time the investor chose to exercise the option, the total cost would be: $3,000 (100 shares multiplied by the $30 strike price) + $200 premium + $80 in commissions for a total of $3,280. Since the investor had 100 shares of Microsoft stock worth $38 after the transaction, the total profit for this transaction would be $520 (prior to tax considerations).
Clearly the investor could have made a higher profit had he/she simply purchased the stock outright. However, many LEAP options are used to hedge investments or serve as an insurance in the event of loss. Consider the same initial transaction, but this time; assume that the stock, for some unforeseen reason, indeed drops in value to $20 per share. Buying the stock outright would have cost $2500 (recall that Microsoft was trading at $25 at the time the investor considered buying the LEAP) and a $5 drop in price would have amounted to a $500 loss plus commissions. As stock commissions tend to be 25% lower than option commissions, that would equal $60 total for both buying the stock initially and also for selling it. The net loss would be $560. But, with a LEAP, the loss is cut to $280 ($200 premium price plus commissions). So while options cut into potential profits, they also provide investors with a safety net that shields against losses. Plus, by locking in a strike price, there is the potential for huge profits if the stock price increases before the expiration period.
However, options can be much riskier than standard stock transactions, because of the all-or-nothing aspect of options.
If an investor buys a LEAP and does not exercise it prior to the expiration date, it becomes worthless and all fees related to it are lost. Imagine if an investor had $20,000 and put all of that money into stocks. Even if the stock lost 50% of its value, the investor would still have $10,000 left (minus commissions).
LEAP's are somewhat like a deposit on stocks. Investors only need to put a little money down to reserve the stock of their choice. If things go well, the investor still needs to pay for the stock when they exercise the LEAP, but are guaranteed a profit (assuming they don't exercise the option before it rises above the strike price!). However, if things go poorly, they do not need to pour more money into the investment.