LEAPS

LEAPS offer investors an alternative to stock ownership. LEAPS calls enable investors to benefit from stock price rises while risking less capital than required to purchase stock. If a stock price rises to a level above the exercise price of the LEAPS, the buyer may exercise the option and purchase shares at a price below the current market price. The same investor may sell the LEAPS calls in the open market for a profit.

Investors also use LEAPS calls to diversify their portfolios. Historically, the stock market has provided investors significant and positive returns over the long term. Few investors purchase shares in each company they follow. Thus, an investor who makes decisions for the long term can benefit from buying LEAPS calls.

LEAPS puts provide investors with a means to hedge current stock holdings. Investors should consider purchasing LEAPS puts if they are concerned with potential price drops on stock that they own. A purchase of a LEAPS put gives the buyer the right to sell the underlying stock at the strike price up to the option's expiration.

Reading the Words: Call, Put, Strike Price, Premium and Expiration

An option is the right to buy or sell a specified amount or value of a particular underlying interest at a fixed exercise price by exercising the option before its specified expiration date. An option that gives the right to buy is a call option, and an option that gives a right to sell is a put option. Calls convey to the purchaser the right, but not the obligation, to buy shares, and they convey to the seller the obligation to sell shares if the contract is assigned. Puts convey to the purchaser the right, but not the obligation, to sell shares, and they convey to the seller the obligation to buy shares if the contract is assigned.

The option holder is the person who buys the right conveyed by the option. A seller of an options contract can also be referred to as the writer of that options contract. The option writer is obligated, if and when assigned an exercise, to perform according to the terms of the option.

In the case of a physical delivery option, the exercise price, which is sometimes called the strike price, is the price at which the option holder has the right either to purchase or to sell the underlying interest. The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. The premium is paid up front to the seller of the option contract and is non-refundable.

The expiration date is the date on which an option expires. If an option has not been exercised prior to its expiration, it ceases to exist, which means that the option holder no longer has any rights and the option no longer has any value. Each American-style option other than a delayed start option may be exercised at any time prior to its expiration. A European-style option may be exercised only during a specified period before the option expires.

A call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option. If the exercise price of a call is above the current market value of the underlying interest, or if the exercise price of a put is below the current market value of the underlying interest, the call or put is said to be out of the money.

Time premium is the amount of the option's price that exceeds its intrinsic value. As an option nears expiration and time decreases, the marketplace is increasingly less willing to pay any premium over intrinsic value until an option is trading purely for intrinsic value at expiration.

How LEAPS Compare with Regular-Term Options

Many of the features of LEAPS are the same as for shorter-term options: the number of shares covered by the contract, exercise and assignment procedures, trading procedures, and margin and commission costs. LEAPS differ from shorter-term options in several ways including availability, pricing, time erosion versus delta effect and strategies.

The unit of trade is 100 of the underlying shares per standard option contract. Equity and exchange-traded fund LEAPS are American-style options. The option may be exercised any business day prior to the expiration date. LEAPS options expire on the third Friday in January.

The Options Clearing Corporation, known as OCC, is the options industry clearing house. When an option has been exercised, OCC will assign the exercise in accordance with its rules to a Clearing Member whose account with OCC reflects the writing of an option of the same series. OCC has an established process to randomly assign exercise notices to firms with an account that has a short option position, and the short option contract is selected from a pool of such customers, either at random or by some other procedure specific to the brokerage firm.

Positions in LEAPS must be aggregated with those of any other option on the same underlying security for the purpose of position and exercise limits. Certain index products may have long-dated options, and investors should refer to the specifications at the exchange sites for descriptions on those.

While they share the same specifications as shorter-term options, the extended lifespan of LEAPS often comes with higher premiums.

Time Erosion and LEAPS

A challenging aspect of shorter-term options is the erosion of the time premium portion of the option's price. Time premium erosion works in favor of short-term option sellers. Conversely, the option buyer must overcome the erosion of time premium to profit from a long option position.

Time erosion of options premium is not linear. Buyers of LEAPS options have less time premium erosion, and LEAPS options offer less leverage. Slow time erosion may frustrate LEAPS sellers.

Using LEAPS as a Hedge

The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices. Professionals often compare this strategy to purchasing insurance on one's home or car. This may give investors confidence to remain in the market. Investors should consider the amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost.

A long put option added to long stock insures the stock's value. The protective put establishes a floor price under which the investor's stock value cannot fall. The protective put buyer pays a premium, which lowers the net profit on the upside, compared to the unhedged stockowner.

The collar strategy lends itself to use as a LEAPS hedge, where time value tends to make premiums higher and the period of protection is longer. A collar writes a call and buys a put with the same expiration as a means to hedge a long position in the underlying stock.

Selling Covered Calls on LEAPS

The covered call is a widely used, conservative options strategy. It requires selling (writing) a call against stock. Investors utilize this strategy to increase return on the underlying stock and provide a limited amount of downside protection. Investors should be aware of the risks involved in a covered call strategy.

If the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, the writer is said to be a covered call writer. Uncovered call writing can involve substantially greater exposure to risk than covered call writing.

Leverage and Risk

Options can provide leverage. An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying product. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment's percentage loss.

Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer may face unlimited risk.

If an investor does not close out or exercise an option prior to expiration, it ceases to exist as a financial instrument. As a result, even if an option investor correctly picks the direction the underlying stock will move, unless the investor also correctly selects the period that movement will take place, the investor may not profit. Options investors run the risk of losing their entire investment in a relatively short period and with relatively small movements of the underlying stock. Unlike a purchase of common stock for cash, the purchase of an option involves leverage. Leverage indicates that the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.

For a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price paid for the position. For an uncovered seller of LEAPS calls, there is unlimited risk. For a seller of LEAPS puts, there is significant risk. Risk varies depending upon the strategy followed. It is important for an investor to understand fully the risk of each strategy.

Margin on Long Options

Purchases of puts or calls with nine months or less until expiration must be paid for in full. Rule 4210(f)(2)(B) of the Financial Industry Regulatory Authority, known as FINRA, provides that, except as provided below in the rule and in the case of a put, call, index stock group option, or stock index warrant with a remaining period to expiration exceeding nine months, no put, call, currency warrant, currency index warrant or stock index warrant carried for a customer shall be considered of any value for the purpose of computing the margin to be maintained in the account of such customer.

In the case of any put, call, currency warrant, currency index warrant, or stock index warrant carried long in a customer's account that expires in nine months or less, initial margin must be deposited and maintained equal to at least 100 percent of the purchase price of the option or warrant. In the case of a listed put, call, index stock group option, or stock index warrant carried long, margin must be deposited and maintained equal to at least 75 percent of the current market value of the option or warrant, provided that the option or warrant has a remaining period to expiration exceeding nine months.

Tax Treatment: The Straddle Provisions

Section 1092 of the Internal Revenue Code defines the term straddle as offsetting positions with respect to personal property. A taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property, whether or not of the same kind. Under Section 1092(a)(1)(A), any loss with respect to one or more positions is taken into account for any taxable year only to the extent that the amount of the loss exceeds the unrecognized gain, if any, with respect to one or more positions that were offsetting positions with respect to one or more positions from which the loss arose.

Options Accounts, the Disclosure Document and Sales Practice

Trading options requires specific approval from an investor's brokerage firm. Under FINRA Rule 2360(b)(16)(A), no member or person associated with a member shall accept an order from a customer to purchase or write an option contract relating to an options class that is the subject of an options disclosure document, or approve the customer's account for the trading of such option, unless the broker or dealer furnishes or has furnished to the customer the appropriate options disclosure documents and the customer's account has been approved for options trading in accordance with the provisions of subparagraphs (B) through (D) of that paragraph.

Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Brokerage firms are required to distribute it to options customers. It is not designed to describe the various potential benefits of options or how investors may use options to enhance their investment strategies or to reduce risk.

Rule 2360(b)(19)(A) provides that no member or person associated with a member shall recommend to any customer any transaction for the purchase or sale (writing) of an option contract unless such member or person associated therewith has reasonable grounds to believe, upon the basis of information furnished by such customer after reasonable inquiry by the member or person associated therewith concerning the customer's investment objectives, financial situation and needs, and any other information known by such member or associated person, that the recommended transaction is not unsuitable for such customer.

Regulation Best Interest provides that a broker, dealer, or natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities, including account recommendations, to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

LEAPS on the Examination

The content outline for the Securities Industry Essentials examination lists options under Topic 2.1.3, Options, in Section 2, Understanding Products and Their Risks. Under that topic the outline lists types of options, puts and calls, and equity vs. index, followed by knowledge of hedging or speculation, expiration date, strike price, premium, underlying or cash settlement, in-the-money and out-of-the money, covered vs. uncovered, American vs. European, exercise and assignment, varying strategies, including long and short, special disclosures, including the Options Disclosure Document (ODD), and the Options Clearing Corporation (OCC) for listed options. Candidates should check the current outline before the examination.

Common Misunderstandings

LEAPS are a different kind of contract from regular options. With the exception of the longer maturity date, equity and exchange-traded fund LEAPS specifications are the same as those for regular-term equity options.

LEAPS can be exercised only at expiration. Equity and exchange-traded fund LEAPS are American-style options, and the option may be exercised any business day prior to the expiration date.

Using LEAPS guarantees success. Using LEAPS does not ensure success, although having a longer amount of time for the position to work is an attractive feature for many investors.

A LEAPS buyer can lose more than the price paid. For a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price paid for the position.

Selling LEAPS puts carries little risk. For a seller of LEAPS puts there is significant risk, and for an uncovered seller of LEAPS calls there is unlimited risk.

LEAPS lose time premium at the same pace as shorter-term options. Time erosion of options premium is not linear, and buyers of LEAPS options have less time premium erosion.

A LEAPS put makes a stock position risk-free. The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices, and investors should consider the amount of protection provided by the put and the cost of the protection.

LEAPS can be bought without a disclosure document. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Key Points

LEAPS are American-style options on certain equities and exchange-traded funds that, upon listing, have terms of greater than 12 months.

With the exception of the longer maturity date, equity and exchange-traded fund LEAPS specifications are the same as those for regular-term equity options.

LEAPS offer investors an alternative to stock ownership, and LEAPS puts provide investors with a means to hedge current stock holdings.

The extended lifespan of LEAPS often comes with higher premiums, and buyers of LEAPS options have less time premium erosion.

For a buyer of LEAPS calls or LEAPS puts, the risk is limited to the price paid for the position, and for an uncovered seller of LEAPS calls there is unlimited risk.

Purchases of puts or calls with nine months or less until expiration must be paid for in full.