Long-term Options - LEAPS

A LEAP (Long-Term Equity AnticiPation Securities) is a call or put option that expires up to two years and eight months in the future. Shorter term options expire within one year. You can buy and sell LEAPS to take advantage of an up move (call options) in a security (stocks and indexes) or a down move (put options).

Call options are popular with some investors because the amount of your loss is limited to the amount you paid for the option. But your potential gain is almost unlimited. Investors buy puts as insurance (hedge) against falling prices.

If you expect a security to increase in price, you would buy a LEAP call. If the security did move to the upside, the price of the LEAP would increase and you could sell it for a profit. However, if the price of the security declined, the value of the LEAP would decline. As the call option nears its expiration date, its value declines very rapidly to just a few dollars. And when it expires, the value of the option is zero. Before the call option expires, you can sell it for a profit or loss, or you can exercise your right to buy the underlying security at a predetermined price.

If you expect a security to move to the downside, you would buy a LEAP put. If the security did decline, the value of the put would increase. But if the security increased in price, the value of the put would decline and at its expiration date its value would be zero. Before the put option expires, you could sell it for a profit or loss or sell the underlying security at a predetermined price.

If you do not want to spend money to own options, you can sell puts and calls to bring in money. But selling options is even more risky than buying them. When you sell an option, the owner of the option (the person who bought it) can force you to buy or sell the underlying security. For example, if you sold a call, you might have to sell the underlying stock at a price that is lower than the current market price. And if you sold a put, you could be required to buy the stock at a price that is higher than the current market value.

Whether you intend to buy or sell options, we recommend that you consult your broker or with an experienced options trader before take any action. Like any option, a LEAP is a speculative investment so you must be prepared to accept extreme price volatility and the possibility of losing all or part of your investment.

For more information read Options - Calls and Puts.

Posted January 16, 2007.