A LEAP of Faith for Traders and Investors

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.

LEAP Collars

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.

Typically, one looks for the sale price of the call equal to the purchase price of the put, making it a no-cost collar. In the example above, this would essentially lock in a sale of XYZ at a price no lower than $90 and no higher than $110 per share. In this case, as would be with most short-dated options, the risk is equal to the reward.

The advantage of using LEAPs for collars is that they can provide greatly reduced risk while still allowing for upside profit potential: Because stocks have an upward bias, most option pricing models (Black-Scholes, for example) will award a long-term out-of-the-money call a greater value than the corresponding put. This creates a situation in which the higher the volatility and the longer the time horizon, the greater the difference in the strike prices in which the call and the put will have the same price.

Assume, for example, that XYZ is trading at $100 and has an implied volatility of 50%. Its January 2006 at-the-money put ($100 strike) would have a theoretical value of about $23, while the January 2006 $110 call would be priced at $24, even though it is $10 out of the money.

This creates a no-cost collar that eliminates all downside risk (your minimum sale price is $100) while maintaining the potential for another of 10% profit if XYZ goes above $110 per share. Note that because the potential gain of just 10% over an 18-month period may not seem appealing for establishing a new position, the more likely application would be to collar an existing stock holding that has substantial but unrealized gains.

Research In Motion ( RIMM), which is up some 650% over the last 52 weeks, might be a good candidate. With the shares trading at $110 and the LEAP options having an implied volatility of 52%, one could buy the January 2006 $110 put for about $27 and sell the $120 call for $26 per contract, or a net debit of $1 for the collar.

The long stock position downside risk is now limited to just $1 (or an effective sale price of $109) while allowing for another $10, or 9%, gain. Again, the prime motivation behind this would be to lock in profits and potentially generate some additional income over the life of the position.

Note that some collared positions may have tax implications, especially if they are deemed a wash sale, so always check with your tax professional regarding your specific situation.

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 steve.smith@thestreet.com.

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