I would like to know more about the short-term price relationship between LEAPS call options and their underlying securities. I haven't found a satisfactory answer in my many books on options. I generally "mark to market" the LEAPS call options in my portfolio using the bid price as a more accurate, albeit conservative, reflection of the actual market value, rather than either the last price (which can be days old in a thinly traded LEAPS call) or the ask price.I've noticed, however, that often -- particularly on or right before the market closes -- the LEAPS call option bid price might move down, even though the underlying security's price is simultaneously moving up. I've assumed that due to the remaining almost-two-year life of my LEAPS, time decay couldn't really be a factor. -- N.B.
Long-term Equity AnticiPation Securities (LEAPS) are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years. As reader N.B. correctly points out, LEAPS don't experience significant time decay if more than a year remains in the life of the contract. Typically the decay curve's slope becomes noticeable with about eight months remaining and accelerates steeply as expiration approaches.
One of the advantages of LEAPS is that because of their long-term expirations, the at-the-money strikes tend to have fairly high deltas and therefore closely track the price of the underlying shares of stock. This can make LEAPS a great alternative for an investor who expects significant long-term growth in an underlying stock but who doesn't want to make the substantial capital outlay required for entering a long-term position in the stock.
Remember, each LEAPS contract, like standard equity options, represents 100 shares of the underlying security, providing tremendous leverage.
There is, however, a potential drawback to buying LEAPS instead of stock: LEAPS don't pay dividends. As more companies move toward paying dividends and as favorable tax rulings are phased in, this may be an important consideration for investors hoping for a steady yield from their portfolio.
As for the day-to-day settlement prices and N.B.'s annoyance at looking at a paper loss when his account is marked to market, that's just the nature of the game. The reason he often sees the bid drop at the end of the day is that the specialist or market maker will typically want to end the session by posting the widest allowable spread.
Take a look and you'll notice that sometimes the offer price goes up even as the underlying stock price remains the same or even falls. Some things can cause a shift in the bid/ask, such as outside orders that present a better price than the current market maker's spread. For a review of how specialists set the market,
This even occurs in equities as specialists need to avoid being held to filling standing open orders. A wide bid/ask reduces the likelihood that a customer will claim his order was "traded through."
Typically the settlement price will be the average of the bid and ask. In thinly traded issues, these settlement prices can indeed fluctuate and may not represent "fair value" from one day to the next. But as the option moves closer to expiration and becomes more actively traded, its fair value will become represented with greater accuracy and frequency. In the meantime, console yourself with the knowledge that you're only looking at a paper loss. If your investment thesis is correct, you'll realize real profits in due time.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to