Continuing the series on options:
This is another in a series on understanding options. Previously I wrote about put options and call options (click on each to read the previous articles). I also wrote an article last week on using puts to limit losses when owning a stock that is going down. This article describes leap options, also known as leaps. Leaps allow you to buy a stock at a fraction of the cost and still benefit from the same rise (using a call option leap) or fall (using a put option leap) in price.
What is a leap?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock (click on the links above to learn more about call and put options). A leap is nothing more than a call or put option that has an exercise date many months or years into the future. It is a way to participate in a stock’s price move without paying full price to own the stock outright.
Critical things to know as an investor in leaps:
1) Leaps are exercised in the same way as call and put options since they are call and put options with a long timeframe before their exercise date. Therefore, each leap controls 100 shares of the underlying stock.
2) Leaps cost the most since the odds of reaching the exercise price over a long timeframe are greater, especially if the current stock price has a lot of variance.
3) Call (and put) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option – the broker may exercise it automatically. Be careful to know your call option’s value on or before expiration day to prevent buying the stock automatically.
Understanding the leverage associated with leaps:
If you are interested in owning shares of stock in a company, but either don’t have the funds to buy 100 shares or don’t want to risk those funds, leaps are a great investment vehicle to consider. Leaps let you participate in stock price changes over a long period of time without the risk of paying funds to buy 100 shares of the stock.
An example showing how a call leap option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.
I do research to find the stock of a company – xyz corporation – with a high probability of going up in price. On October 1, 2008 the price of xyz corporation stock is trading at $50 per share. I decide to purchase a January 2010 call option with a $75 strike price that expires the third week of that month. This call is trading at $10 which means I pay $1,000 ($10 price x 100 shares of underlying stocks) to buy the call option.
By January 15, 2010, the price of xyz stock rises to $125 and I tell my broker to exercise the option. The call option forces the call seller to sell these 100 shares to me at $75 each for a total cost of $7,500 ($75 x 100). I can then sell these 100 shares of xyz stock on the market for $12,500 ($125 price x 100 shares of stock) and have just pocketed a $5,000 profit ($12,500 – $7,500 purchase cost). However, I paid $1,000 for the call option so my net is $5,000 – $1,000 = $4,000. This is a 400% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the call option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.
The leveraging comes from only paying $1,000 to get a $4,000 profit, which equates to a 400% return on investment. The alternative would have been to pay $5,000 on October 1, 2008 to buy 100 shares of stock and then selling them for $12,500 on January 15, 2010 for a profit of $7,500, which equates to only a 150% return on investment. If the stock has risen much more over the long period of time, then the return against the $1,000 purchase price of the leap would be even more dramatic since every $10 increase in the price of the stock equates to another 100% return on my investment in the option ($10 per stock x 100 shares is $1,000 increase in those stock verses the $1,000 investment in the leap).
What is the potential loss with a leap?
The main benefit of using a call option leaps to make money on stocks with rising prices instead of buying the stock is that your maximum loss of investment is limited to the total purchase paid to buy the call ($1,000 in the above example). If the stock price never went higher than $75, then the call would expire worthless and the investor would loose the $1,000 investment. If I had bought the stock instead, my full $5,000 investment would have been at risk verses only $1,000 to buy the leap. Similarly, the use of a put option leap limits your investment loss only to the purchase of the leap.
The other benefit was the ability to participate in the increasing price of 100 shares of a $50 stock by only paying $10 per share through the leap to get the associated increase in value. I paid 1/5th of the stock price to control the same 100 shares of stocks over a long period of time.
The use of a leap (call or put) is another way of making money when the stock price is going up or down over a long period of time without having to put the full amount of funds at risk that would be required to actually purchase and hold the stock. However, the price of leaps tend to be much higher than shorter term options due to the potential of a stock to reach the strike price over the longer period of time. Don’t invest too much on leaps in any one company. Diversify and use leaps as one investment tool among many as part of your investment strategy.
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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.