What in the world are LEAPS?

By Daniel Jimenez • Bankrate.com

I had a dream in which my editor asked me to write an article explaining the basics of either: A) quantum physics, B) brain surgery, or C) equity options. I made the mistake of choosing equity options. Jokes aside, long-term equity anticipation securities (LEAPS) are a treacherous subject matter.

LEAPS are long-term stock and stock index options that have expiration dates of one to three years. Long-term options were created in 1990 as an alternative to ordinary equity options, which typically expire in one to four months. LEAPS are considered less risky than regular options because the price of the stock or index has a longer time to perform the way you hope it will.

As with regular equity options, the owner of an equity LEAPS call has the right to buy a pre-determined amount of stock, at a pre-determined price, for a specified period of time. LEAPS calls give you the opportunity to cash in on a stock’s rise without actually having to buy the stock. Buying the option is cheaper than buying the stock, and it could also make you a greater profit.

Likewise, the owner of a LEAPS put has the right, but not the obligation, to sell a stock at a specific price for a specified time. LEAPS puts give stockholders medium- to long-term insurance in case the stock price goes down. You with me so far?

The downside of LEAPS is the same that you’d have with any other kind of option. You’re taking a risk that your strategy pans out before the options expire. With a call, you could wind up losing your entire investment if you buy the option and the price hits bottom. Similarly with a LEAPS put, you lose the premium you paid if your LEAP expires out of the money.

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Another drawback to LEAPS is that they are not available for all options, so your choices tend to be limited. You can get a directory of listed options by visiting the Options Clearing Corporation Web site. There’s also a list of stocks that offer LEAPS available at the Nasdaq’s Web site. Also, beware that the premium on long-term options is generally higher than on the short-term kind.

You can tell when LEAPS are due to expire by looking at the accompanying stock symbols, which are then modified by either the letter L, V, W or Z. For example, LEAPS on IBM stock (NYSE: IBM ) might use the symbol WIB and LEAPS on General Electric stock (NYSE: GE ) would be labeled WGE. LEAPS on IBM expiring next year might use the symbol ZIB, while those expiring the following year would use LBM.

For instance, an ZIB Jan 80 call gives you the right (but not the obligation) to buy 100 shares of IBM at 80 bucks a share. So a ZIB Jan 80 call would expire on the third Friday of January 2001. You’d have until that day to decide whether to trade, exercise or let the option expire. If you don’t get rid of a losing option before it expires, then kiss your money goodbye.

Here’s an example of how symbols show you when LEAPS are set to expire:

• IBM (Standard Option expires October 2000): IBM Oct 80 Call
• IBM (LEAPS Option expires January 2001): ZIB Jan 80 Call
• IBM (LEAPS Option expires January 2002): WIB Jan 80 Call

All equity LEAPS contracts expire the Saturday following the third Friday in January. Keep in mind that everyone who intends to trade options needs (and is required by the SEC) to read Characteristics of Risks of Standardized Options, available by calling (800) OPTIONS or by checking out the Chicago Board Options Exchange’s Web site. You should also check out How to Trade Options.

In conclusion, LEAPS are a way to trade options while lowering your risk. Used correctly, they can be employed as a hedge; a LEAPS put, for example, can lock in gains on stock that you’d rather not sell, for tax reasons or whatever. Having said that, don’t start thinking that options are appropriate for beginning investors. Thousands of options players thought they knew what they were doing up until the day after the market crashed in 1987. In other words, it’s better to look before you LEAPS.

DANIEL JIMENEZ is a regular contributor to Bankrate.com.

— Posted: April 5, 2000