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Minyan Mailbag: Risk and Value of LEAPS


There are no easy and hard rules. Option trading is very risky and things move around a lot.

Prof. Succo,

I have purchased options in many situations as either a trade or as a hedge against other equity plays. One area that I have remained on the sideline is in the use of LEAPS (Long-Term Equity Anticipation Securities). My question is how do you determine the value / risk of LEAPS vs. purchasing the common stock? I find myself wanting to leverage some of my stock picks, but do not because of my inability to determine if a particular LEAP fits my investment style. Are there any simple guidelines to follow when considering the complexity of these trading strategies?

I am a simple man of even simpler words. Thanks for always giving your time to those of us who are on the outside looking in and trying to get ahead.

Minyan Phil


First, remember all option prices are relative: in choosing an option to buy, always compare different durations and strikes to see if one is better than another. But the over-riding criteria is timing, so if there is no big difference in relative price, choose the option that best fits your objectives as far as hedging. When you buy an option (either a put against long stock or a call in lieu of stock), it is a hedge.

It is a hedge in the sense that you expect some type of volatility: you buy a put against long stock because you are concerned about something over some period of time (you expect volatility) or you buy a call in lieu of stock because you want the upside, but are worried about volatility on the downside. You always just buy stock or remained un-hedged if you are not concerned about volatility (the longer your time horizon, the less you should be concerned about volatility).

A LEAP is a long term option and has a higher absolute price obviously. Because of the high nominal premium you risk much more if you are wrong (there is no volatility and the price of a leap will drop much more than that of a short term option). You weigh this against timing: there is a high probability that the shorter term option will not protect against an eventual volatility event.

The best way to compare prices is implied volatility, which I have explained in other articles: compare the implieds of the LEAPs to other options to make sure the prices are not drastically different. But there may be a reason why the prices are such, so factor that in too.

In addition, do break-even analysis to give you an idea of where one option outperforms another over a certain time period. Timing and nominal price (premium) is the crucial thing.

There are no easy and hard rules. Option trading is very risky and things move around a lot.

No positions in stocks mentioned.

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