When considering any options strategy, you may want to think about Long-Term Equity AnticiPation Securities® (LEAPS®) if you are prepared to carry the position for a longer term. While using LEAPS® does not ensure success, having a longer amount of time for your position to work is an attractive feature for many investors. In addition, several other factors make LEAPS® useful.
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. A buyer of a LEAPS® call has the right to purchase shares of stock at a specified date and price up to three years in the future. 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.
What's the Downside?
If you are a buyer of LEAPS® calls or LEAPS® puts, the risk is limited to the price paid for the position. If you are an uncovered seller of LEAPS® calls, there is unlimited risk. As 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.
Stock vs. LEAPS®
There are many differences between an investment in common stock and an investment in options. Unlike common stock, an option has a limited life. An investor can hold common stock indefinitely, while every option has an expiration date. 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.