Active traders tend to ignore LEAPs , or Long-Term Equity AnticiPation Securities, because they don't provide the same leverage as short-term options. Stock owners tend to avoid LEAPs because they perceive them as having too much leverage relative to the underlying shares. But because LEAPs occupy this middle ground, they can help bridge the gap between active speculation and passive, buy-and-hold investing. They're valuable in reducing the volatility and managing the risk of your portfolio. LEAPs are options issued with January expiration periods, and they have initial life spans exceeding one year. Most stocks will have two LEAP years (that currently means January 2005 and January 2006) available for trading. One advantage of LEAPs over shorter-term options is that time decay has a negligible affect on their value. LEAPs' advantages over ownership of the underlying shares include lower cost and reduced volatility. With the implied volatility on many stocks' options near historic lows, now may be a good time to consider building an "options" stock portfolio through the purchase of LEAP calls. To determine whether an option is inexpensive, you need to look at its level of current implied volatility relative to the stock's historical volatility. For example, compare Best Buy ( BBY) with Burlington Northern ( BNI), both of which now have implied volatility in the 27% region. For Best Buy, this represents the lowest level of its 52-week historical average in roughly a year and a half, making the options look relatively inexpensive. But Burlington's current options prices are near their highest levels for the year, so they're no bargain. With Best Buy now trading at $52, the January 2006 call with a $50 strike would have a theoretical value of $9.70. This means you could control 100 shares of Best Buy with a capital outlay of just $970, significantly less than the $5,200 (or $2,600 with 50% margin) needed to buy the underlying shares. The lower cost of the LEAPs also represents its correspondingly lower risk compared with owning the stock. But LEAPs do have some drawbacks. In the Best Buy example, your break-even point is $59.70, meaning you don't make a profit until the stock climbs some 14% from current levels. Also, the LEAPs market is significantly less liquid than the cash stock market. The wider bid/ask spreads of the options and the difficulty in executing trades in a timely fashion are two factors that can negatively impact the LEAPs' return on investment. Another consideration is dividends: Unlike the stock holder, the owner of a LEAP call option is not entitled to collect dividends. In Best Buy's case, this amounts to 40 cents per share annually.
Another often-overlooked application of LEAPs is using them to lock in gains or to limit the risk in volatile stocks by establishing a collar. A collar is the simultaneous purchase of a put and sale of a call with the same expiration but different strike prices done in conjunction with a long stock position. An example construction would be buying (or already owning) 1,000 shares of XYZ at $100, buying 10 January $90 puts and selling 10 January $110 calls.