ssrn.com/abstract=1919066

Equity LEAPS Calls vs. Stocks: An Empiric al Study for

Long-Term Spec ulation

S. Leila Beheshti Shirazi

University of Malaya

Izlin Ismail

University of Malaya

ABSTRACT

Long-Term Equity Anticipation Security or LEAPS is a call option introduced as a more conservative

security that can replicate a common stock position. This study’s objective is to examine the effect of

applying the strategy of “Buying In-The-Money LEAPS Calls vs. Purchasing Stocks” proposed by CBOE

on the performance of traders in terms of risk and return trade-off and the risk-adjusted performance in

practice, using a sample of 54 common stocks listed on NYSE and NASDAQ and 54 LEAPS calls on the

same underlying stocks listed on CBOE during 2008-2010. The results indicate that LEAPS calls are not

a preferred financial instrument to replace common stocks for risk-averse traders. When the stock market

experiences a progressive downturn trend, the portfolios of LEAPS calls provide much higher negative

returns, significant loss and poor performance as well as higher levels of volatility relative to the

portfolios of common stocks. The results of this study also suggest that risk-seeking traders, who can

tolerate the higher level of risk in compensation for higher returns, choose the portfolio of LEAPS calls

with high Book-To-Market (BTM) ratio assets. This portfolio is less volatile relative to the portfolio of

LEAPS with low BTM ratio and provides higher rates of return in comparison to the portfolios of

common stocks in favorable market conditions.

Keywords: Equity LEAPS call, common stock, long-term speculation, return, volatility, mean, variance,

risk-adjusted performance, Sharpe ratio, Treynor ratio, Jenson Alpha.

JEL Classification: G11, F39

1. Introduction

Derivative securities have become an integral part of the financial markets in the past four decades due to

their important functional uses including risk management or hedging, speculation, and arbitrage

opportunities in the marketplace (Lapan et al. 1991; Bartram, 2003; Apostolou et al. 2005; Kumar,

2007). Based on different motives, some traders purchase derivatives to manage their financial risks while

others use these securities to speculate on price movements of the underlying assets (Kumar, 2007). For

the most part, derivatives are used as a risk management tool rather than for speculation by portfolio

managers and individual investors1. This study will, however, focus on the speculative use of derivatives.

Speculation is defined as buying, holding and selling of any valuable financial asset to profit from the

fluctuations in its price (Hiriyappa, 2008). Any speculative decision to buy or sell a financial asset

involves market timing to obtain the best price (Emery, 1896). Due to the need to precisely time the

1 It is usually believed that the term speculation refers to a short-term financial action and the term investment to a long-term one (Brandes, 2003; Hiriyappa,

2008). However, Nagarajan & Jayabal (2011) avoid distinguishing them based on their holding period and explain that the distinctions between speculation

and investment are the degree of risk involved and the motives of traders. The element of risk involved in speculation is significantly higher than that of

investment. A speculator tends to take a higher level of risk when anticipating a higher level of return in the future. Also, an investor’s motive is to increase

his/her income from the securities whereas a speculator’s motive is the capital appreciation. Thus, even those who buy and hold securities for decades, may be

classified as speculators, except only the rare few who are primarily motivated by income or safety of principal rather than selling at profit. Thus, in this paper

the term investors and long-term speculators are used interchangeably when the motives of both investors and long-term speculators are earning profit from

price fluctuation in the future.

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market, speculation on derivative securities which usually have a short life span entails running the risk of

loss in the expectation of high reward (Farhi & Borghi, 2009). Bauer, Cosemans & Eichholtz (2008)

found evidence that most individual investors who trade short-term options to speculate on stock price

movements have incurred substantial losses on their investments and they concluded the poor market

timing was the main determinant of their under-performance.

As such, the development of longer maturity derivatives has reduced the risk of speculation on

derivatives and removed the need for precise timing of the market. One of these longer maturity

derivatives is LEAPS or Long-Term Equity Anticipation Security. LEAPS is a long-term option with the

expiration date of up to three years (CBOE, 2001; Lasher, 2007). Compared to the short-term options,

LEAPS provide a longer time frame for option traders to benefit from favorable price movement in the

market. LEAPS traders do not need to time the market in a short run and be too concerned about the

accuracy of their predictions (CBOE, 2001; Apostolou et al. 2005). The longer-term maturity of LEAPS

contracts has removed the most inhibiting factor of options, i.e. market timing (Thomsett, 2009).

Generally, option is a best way to gain leverage in the stock market and at the same time speculate on

favorable price movement in the underlying assets. Due to the effect of leverage, small changes in the

value of the underlying assets produce big changes in the value of options (Wilmott, Howison &

Dewynne, 1997). In other words, the leverage inherent in options can magnify the returns on investment

while investors only pay a fraction of total capital required for the securities (Apostolou et al. 2005;

Lasher, 2007). However, leverage can magnify the risk of investment as well and traders have to take a

greater level of risk for speculating on options relative to stocks (Lasher, 2007).

Like options, LEAPS offer investors a way to take long-term levered positions in the derivatives

market (OIC, 2008). Due to the effect of leverage, gains from LEAPS calls can be sometimes 4-5 times

greater than those of the underlying stocks (Lasher, 2007). This factor has encouraged a new generation

of market participants, who are more risk takers, to become interested in trading LEAPS calls instead of

common stocks to earn greater returns from the favorable price movement of the underlying assets. On

the other hand, it is believed that buying LEAPS calls can be a more conservative approach relative to

purchasing common stocks outright in a volatile stock market condition because investors will not be

putting their whole capital at risk and just limit the risk to the premium amount paid (Thomsett, 2009).

Due to these factors, many financial advisors and option specialists currently (McMillan, 2002; Taylor,

2008; Rahemtulla, 2009, Zigler, 2010) suggest investors and long-term speculators to construct their

portfolio with LEAPS calls rather than stocks and/or replace the existing stocks in their portfolios with

LEAPS calls. Moreover, CBOE has introduced a new investment strategy of “Buying In-The-Money

LEAPS Calls vs. Purchasing Stocks” in its official website to inspire investors to replace LEAPS calls

with the underlying stocks in their portfolios of investment. Therefore, many option traders are attracted

to buy LEAPS calls to speculate in the stock markets over a longer period of time (Allaire & Kearney,

2002). However, we were unable to find a study in literature to examine the performance of the long-term

speculators by applying this strategy in practice in terms of risk and return trade-off and risk-adjusted

performance. As such, the risk and return tradeoff and the performance of a portfolio of LEAPS calls in

practice are still under question. Investors are unaware of the actual level of returns and risks that they

will experience in adopting this strategy. There is, thus, a need for investors to ensure the preference of

investing on a portfolio of equity LEAPS calls over a portfolio of common stocks.

This study attempts to measure the risks, the returns and the risk-adjusted performances of the

portfolios of equity LEAPS calls and those of the portfolios of the underlying stocks to compare them

together and explore any preference of each. The risk-adjusted performance of these portfolios would be

measured using the Sharpe, Treynor and Jenson measures. This study also attempts to increase the

understanding of investors or long-term speculators regarding their success or failure in the market by

buying LEAPS calls instead of common stocks.

The findings of this study can help those investors or long-term speculators who do not have sufficient

capital to purchase various expensive stocks in the stock market and instead are willing to buy LEAPS

calls in the derivative market to benefit from favorable price movement. This study also would make a

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contribution to the literature in the area of speculating in options, specifically LEAPS calls. It is also

anticipated that this study will motivate others to conduct further research on speculating in LEAPS calls

within different periods of time and investigate the performance of investors or long-term speculators

adopted this investment strategy in the financial markets.

2. Literature Review

Investors’ preference to trade options rather than stocks is to benefit from lower transaction costs, to

avoid tax exposure and to bypass stock market restrictive rules (Kolb & Overdahl, 2007). As the value of

options depend on the price of the underlying stock, buying options is viewed as a substitute for direct

purchase or sale of stocks (Bodi, Kane & Marcus, 2009). In this context, Kolb & Overdahl (2007) explain

that many investors trade options to speculate on the price movement of the underlying stock.

Educated traders with speculative motives have moved toward trading LEAPS rather than short-term

options (Roth, 1994). LEAPS were introduced by Chicago Board Option Exchange (CBOE) in 1990 as a

new investment tool (Roth, 1994; Allaire & Kearney, 2002; CBOE, 2001). Longer expiration period of

LEAPS overcomes the ongoing struggle of option traders with time. Also, the length of time included in

this security allows the underlying security to continue to compound over the time (Allaire & Kearney,

2002; OIC, 2008). Moreover, LEAPS provides less leverage for investors because the buyers of LEAPS

have less time premium erosion relative to the buyers of short-term options (CBOE, 2001; OIC, 2008)

These factors make LEAPS less volatile and risky (CBOE, 2001; Weiyu Guo, 2003) and helps LEAPS

traders lower their risk on investing in options (Holland & Wingender, 1997).

Currently there are a limited numbers of studies on LEAPS. Among the few existing studies, there are

some empirical explorations concerning the pricing of SPX LEAPS (Bakshi et al. 2000) and equity

LEAPS (Weiyu Guo, 2003) through Black-Scholes model, the volatility dynamics of LEAPS on S&P 500

stock market index (Bollerslev & Mikkelsen, 1999), trading volume of LEAPS (Weiyu Guo, 2003), and

the relationship between the introduction of LEAPS and changes in the value of underlying stocks

(Lundstrum & Walker, 2005).

Generally, LEAPS is classified into two main categories: Equity LEAPS and Index LEAPS. Equity

LEAPS are American options that can be exercised at any time before the expiration date, while Index

LEAPS are European options which can only be exercised at the maturity (Roth, 1994; Allaire &

Kearney, 2002). The exercise of equity LEAPS results in the delivery of the underlying stock but index

LEAPS are settled with cash (OIC, 2008).

McMillan (2002) claims that equity LEAPS calls can be used as a substitute for common stocks for

investors intending to reserve their capital. Compared to stocks, equity LEAPS calls can provide investors

a greater percentage return due to the leverage effect, limited risk of investment to the premium amount

paid, less capital requirement at a fraction of buying stocks outright, and the same performance as stocks

(CBOE, 2001).

2.1. Return on Equity LEAPS Calls

Due to the inherent leverage, options provide magnified returns on investment (Apostolou et al. 2005;

Kolb & Overdahl, 2007; Gurusaour, 2009). Evidence on S&P index shows that the returns on call options

are significantly larger than those on the underlying stocks; by an average of two per cent per week

(Coval & Shumway, 2001). This is due to the fact that options have a convex payoff (Begley & Feltham,

1999; Guy, 1999; Bryan, Hwang & Lilien, 2000) while the payoff on stocks is linear.

With regard to moneyness, deep in-the-money (ITM) LEAPS calls have higher delta and more

potential to earn significantly higher returns (CBOE, 2008; OIC, 2008) than at-the-money (ATM) LEAPS

calls with relatively low delta and less potential to earn high returns (OIC, 2008). ITM equity LEAPS

calls can even provide much higher returns on the original investment for investors relative to the returns

on ATM LEAPS calls and common stocks. In this context, Lowel (2009) explains that deep ITM (DITM)

call strategy is the best way to artificially own a stock with half the money outlay and less risk.

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2.2. Risk on Equity LEAPS Calls

Higher return is not the only factor that investors consider in an investment decision. The other significant

parameter is the risk on investment that investors aim to decrease it as much as possible. Unlike other

investments with unlimited risks, LEAPS offers a known risk to traders which is limited to the premium

amount paid for them (OIC, 2008). As noted before, an equity LEAPS call holder benefits from stock

price appreciation but does not incur loss more than the premium paid if the share price fall (Allaire &

Kearney, 2002; McMillan, 2002). This means that trading LEAPS is less risky than the underlying stock

in terms of the total value of investment. In this respect, McMillan (2002) claims that if investors

substitute LEAPS calls instead of their stocks, they will suffer less risk due to the cheaper cost of LEAPS

than that of stocks.

However, it is significant to note that LEAPS calls have high implied volatility which is known as a

significant risk factor (Allaire & Kearney, 2002). The high implied volatility of LEAPS calls is a great

concern of traders intending to invest on LEAPS calls and may prevent them from investing in LEAPS

calls.

2.3. Risk and Returns of a Portfolio of Equity LEAPS Calls

LEAPS calls can be used to construct a long-term portfolio of stocks but with less capital outlay

(McMillan, 2002). Taylor (2008) suggests investors create a portfolio of stocks with LEAPS because

LEAPS can provide them greater diversification, manageable risk, and higher return.

The higher implied volatility of LEAPS calls (Allaire & Kearney, 2002) and volatility factors create a

significant variation in portfolio returns (Coval and Shumway, 2001). In this regard, Banerjee et al.

(2007) found evidence that VIX2 variables (volatility) significantly affect excess returns for most

portfolios. This relationship is stronger for portfolios that have higher beta values (like a portfolio of

options). It implies that the high implied volatility of LEAPS calls will result in larger excess returns for a

portfolio of LEAPS calls.

An option portfolio has higher beta and risk profile compared to a stock portfolio (Crouhy, Galai &

Mark, 2002; MacMilan, 2002). The high beta of an option portfolio makes its returns significantly

volatile. Consistently, Sears and Trennepohl (1982) found evidence that systematic risk or market

variance for an option portfolio is significantly greater than that of stock portfolio. However, they found

that the systematic risk may be reduced with the greater diversification and elimination of unsystematic

risk in a portfolio.

3. Data and Methodology

3.1 Data

The sample of underlying stocks is selected among the common stocks listed on the New York Stock

Exchange (NYSE) and NASDAQ stock market. The sample equity LEAPS calls, on the same underlying

stocks, have been chosen from the listed LEAPS calls on the Chicago Board Options Exchange (CBOE).

The S&P 500 EWI is chosen as a benchmark against our sample of equally weighted stock portfolios. The

period chosen for this study is a three year period from January 2008 to December 2011. As equity

LEAPS calls are good investment strategy when the market is bullish and considering the fact that the

economy of USA was expected to flourish in the mid 2008 according to the Wall Street Journal in April

2008, thus, this time period has been selected to test this strategy.

The samples are not randomly selected and are based on several criteria. First, we have picked the

sample securities from different industries to meet the diversification principle of Modern Portfolio

Theory (MPT) model to remove the unsystematic risk of the portfolios. Second, we have chosen the

sample based on their book-to-market (BTM) ratios. Several studies have indicated a strong relationship

between returns on assets and their BTM ratios (Rosnberg, Reid and Lanstein, 1985; Davis, 1994; Chan,

2 VIX or volatility index is introduced by CBOE in 1993. This index is calculated from the S&P 100 (OEX) stock index

options and originally computed on a minute-by-minute basis from the implied volatility of eight OEX option series.

Page 5

Hamao, and Lakonishok, 1991; Capaul, Rowley and Sharpe, 1993), and as such, this issue has also been

taken into consideration in this study. Fama and French (1995) observed that two classes of stocks tend to

do better than the market as a whole: small caps stocks and stocks with a high BTM ratio. Following that

study, Barber, Lehavy, and Trueman (2006) designed two portfolios of high BTM and low BTM and

measured their returns. Thus, accordingly to conduct our study, we have constructed two portfolios of

stocks and two portfolios of equity LEAPS calls, one with high BTM ratio and another with low BTM

ratio, respectively, in order to ensure the robustness and sensitivity of the results in terms of returns.

Third, among the equity LEAPS calls written on the underlying stocks, only ITM equity LEAPS calls are

selected for the strategy proposed by CBOE and also consistent with the literature emphasizing ITM

options as a good substitute for common stock due to their high delta.

The relationship between portfolio performance and the number of stocks held in the portfolio has

always been an area of interest to many financial economists. Statman (1987) shows that a portfolio of

30-40 stocks can effectively achieve efficient diversification and Chung (2000) exhibits that a well-

diversified portfolio contain at least 27 securities. Consistently, Wang and Yang (2007) based on the

ordinary least square method (OLS) and GARCH Model found that the optimal portfolio size in terms of

the number of stock holdings is between 21 and 28 with portfolio returns maximized and volatility

minimized. Therefore, we have decided on a sample size of 27 securities in each of the four equally

weighted portfolios.

A LEAPS position can be held even longer than three year which is the maximum expiration period of

LEAPS. LEAPS calls can be repeatedly rolled forward through a process of selling the old option and

then purchasing a new one with the same strike price but a later expiry date (Allaire & Kearney, 2002).

Through this process, long-term speculators can roll LEAPS calls over and over for many years. The

objective of rolling LEAPS over is to allow the underlying assets to appreciate over time and create profit

for LEAPS holders. To show the possibility of holding the LEAPS calls for a longer period of time and

the opportunity of appreciation in the underlying securities in this study, LEAPS calls with 2 year

expiration date traded in January 2008 are rolled over in Aug 2009 at the same strike price but later expiry

date (January 2011). The LEAPS portfolios have been rebalanced again in August 2009 to become equal-

weighted.

3.2 Methodology

In this study, the strategy of Buying In-The-Money LEAPS Calls vs. Purchasing Stocks proposed by

CBOE is modeled in the context of portfolios of assets. As such Markowitz’s (1952) MPT is employed

for this purpose. Moreover, the strategy to buy and hold is used to measure the returns, risks and risk-

adjusted performance of these portfolios. The reason behind choosing this strategy is that, a buy and hold

strategy is a very popular investment strategy in the financial markets as investors believe good assets

usually grow over a long period of time, even if they seem to decline at some points. Also, buy and hold

is the preferred system of investment for small investors who are looking for a way to minimize

transaction costs.

In a fashion similar to the studies of stock returns by Fisher and Lorie (1968), stock and bond returns

by Ibbotson and Sinquefield (1976) and return and risk of alternative call option portfolio by Merton,

Scholes and Gladstein (1978), this study attempt to measure average rates of return and risks (or standard

deviation of returns) of these portfolios over the period of this study to investigate any preference of each.

Like prior studies and for the sake of simplicity, the costs associated with commission, tax, and

transactions are not taken into consideration. To measure the monthly returns of a common stock, we

follow the equation of Ibbotson and Sinquefield (1976) as,

R i,t = [(P i,t + D i,t) / P i,t-1] -1, (1)

where Ri,t is the common stock total return during time t; Pi,t is the stock i’s closing price at the end of

time t; and Di,t is the stock i’s dividends received during time t and reinvested at the end of time t.

Page 6

The returns of LEAPS calls are calculated similar to those of short-term call options. According to a

study on stock option returns by Xiaoyan Ni (2007), the returns of an individual LEAPS call from one

expiration date to next is measured as,

R i,t = [Max(S t — K, 0) / P] -1,

where Ri,t is the average return on LEAPS calls of stock i at the end of time t; S t is the closing price of

stock i at the end of time t; K is the strike price of the LEAPS at its expiration date; and P is the premium

amount paid to buy an equity LEAPS Call.

However, in the context of portfolio, we have to measure the rates of return of the portfolios, rather

than the individual assets. Based on MPT, the rate of return on a portfolio is the weighted sum of the rates

of return of the individual securities within the portfolio as,

R P,t = ∑27i=1 wi,t. Ri,t

where R P,t is the rate of return of a portfolio during time t; w i,t is the weight of asset i in the portfolio; R

i,t is the rate of return of asset i at the end of time t.

Furthermore, the risk of a portfolio is measured by the standard deviation of its returns σ(Rp). MPT

uses standard deviation to measure risk or volatility of a portfolio (Bodi, Kane & Marcus, 2009). This

model defines a portfolio‘s risk as a function of the weighted sum of variance and the correlation of

component assets (Markowitz, 1952) as,

σp,t =∑27i=1 w2

where σ P,t is the risk or volatility of a portfolio during time t; wi,t is the weight of asset i in the portfolio;

w j,t is the weight of asset j in the portfolio; σ2

of asset j in the portfolio; and ρij is the correlation coefficient between the returns on assets i and j.

To obtain a reliable conclusion about the performance of these portfolios, only looking at their risk-

return tradeoff is not enough. It is necessary to utilize other tools that go beyond the mean-variance

framework. So, three types of reward-to-risk ratios including the Sharpe, Treynor, and Jenson Alpha are

applied to examine the risk-adjusted performance of these portfolios. These ratios are often used together

to rank the performance of portfolios or mutual fund managers.

The Sharpe Ratio or reward-to-variability ratio measures the excess return per unit of total risk in an

individual investment asset or a portfolio of assets. It is defined as,

S= RP — Rf

where RP is the return of a portfolio of assets, Rf is the risk free rate of return, and σP is the standard

deviation of the returns of a portfolio.

The Treynor ratio measures the excess return per unit of market risk in an individual investment asset

or a portfolio of assets. In other words, the Treynor ratio is similar to the Sharpe ratio, with the difference

that the Treynor ratio uses beta or systematic risk as the measure of volatility instead of standard

deviation or total risk. Treynor ratio is a more appropriate approach when an investor holds a well-

diversified portfolio and the unsystematic risk of investment is diversified away. This ratio is defined as,

T= RP — Rf

where RP is the return of a portfolio of assets, Rf is the risk free rate of return, and βP is the beta or

systematic risk of a portfolio of assets. Like the Sharpe ratio, the higher the Treynor ratio, the better the

performance of the portfolio.

Pilotte and Sterbenz (2006) explored the risk-returns characteristics of two equally weighted portfolios

of bills and bonds by applying both ex-ante and ex-post Sharpe and Treynor ratios. We follow the same

methodology in this study to measure the ex-post Sharpe and ex-post Treynor ratios of these portfolios.

The ex-post Sharpe ratio proposed in their study is,

Ex-post Sharpe ratio= 1/T Ʃt t=1 XRt.

SD (XRt)

where XRt is the excess return of the portfolio and SD (XRt) is the standard deviation of XRt. Hereby, we

rewrite the equation as,

(2)

(3)

i σ2

i+ ∑27i=1 ∑27j=1 wiwjσiσj ρij (4)

Ex-post Sharpe ratio= 1/TƩtt=1(Rp,t – Rf,t). (7)

where Rp,t is the average return of portfolio at the end of time t; and Rf,t is the avearge risk free rate at the

end of time t.

Furthermore, the ex-post Treynor ratio is rewritten as,

Ex-post Treynor ratio= 1/TƩt t=1(Rp,t – Rf,t). (8)

ϐp,t

where ϐ is the average ϐ for the portfolio at the end of time t.

Jenson’s alpha is another risk-adjusted measure used in this study to determine the abnormal returns

of these portfolios over the theoretical expected rates of return. According to Jenson (1967), the equation

of Jenson’s alpha is,

α p = Rp – [Rf+βp.(RM-Rf)]

And, the ex-post Jenson alpha is as,

Ex-post Jenson alpha = 1/TƩtt=1[Rp,t + βp.(RM,t – Rf,t)]. (9)

If a portfolioss return is even higher than the risk adjusted return, that portfolio is said to have positive

alpha or abnormal returns.

According to Fama & MacBerth (1973) and Ross, Westerfield and Jaffe (2010), the beta (β) of a stock

is the relation of its returns with that of the financial market as a whole that is defined as,

where im represents the covariance between the stock and the market, and 2m represents market

variance. To calculate the beta of each portfolio, we have computed the average covariance of the

monthly rates of return of the portfolios and the rates of return of S&P 500 EWI, then divided them by the

variance of the returns of S&P 500 EWI during the study period.

4. Research Results

4.1. Mean-Variance analysis

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Table 1 shows the mean of all the four portfolios constructed as well as the mean of the S&P500 EWI are

negative within the study period. Long-term speculators holding these portfolios incur loss due to the

average negative rates of returns. However, the portfolios of LEAPS calls have generated significantly

greater negative rates of return and loss relative to the stock portfolios. Since the mean of the stock

portfolios are greater (or less negative) compared to the mean of the LEAPS calls portfolios, the long-

term speculator holding the portfolios of LEAPS calls have experienced much more loss within this

period. The greater negative rates of return of the portfolios of LEAPS calls are consistent with the

theoretical prediction concerning the effect of leverage that magnifies both the positive and the negative

rates of returns. As, the average rates of return of the underlying stock portfolios were negative in this

study, leverage magnified the negative rates of return for the portfolios of LEAPS calls.

It is significant to note that the mean of the LEAPS calls portfolio with low BTM ratio is significantly

smaller (or more negative) relative to the portfolios of LEAPS calls with high BTM ratio. The portfolio of

LEAPS calls with low BTM ratio can create the greatest negative mean return and loss in comparison to