LEAPS stands for Long-term Equity Anticipation Securities. Leaps are long dated call or put options on stocks (equities) or ADRs (American Depository Receipts). The expiration date of LEAPS can be up to three years from the date of purchase. All LEAPS options expire in January on the Saturday following the third Friday of the month. LEAPS options are American style which means they can be exercised on any business day prior to maturity.
LEAPS allow an investor to participate in the appreciation of a stock without having to buy the stock outright. For example, Exxon (XOM) was in the news today for having the highest quarterly and annual earnings of any company in history. Their stock XOM closed trading today at $63.11 up $1.82 on the day.
If you wanted to buy an option that matured next January (one year from now) you could buy an option that was slightly in-the-money call - the Jan 60 2007 (ODUAL) which is in the money $3.11 or a slightly out-of-the-money call - the Jan 65 2007 (ODUAM) which is out of the money by $1.89. The ODUAL sold for $8.40 and was up $1.30 on the day. Buying one contract would cost you $840.00 and would give you the right any time between now and January 2007 to buy 100 shares of Exxon stock for $60 per share. To buy 100 shares out right today would cost you $63,110.00.
Say the price of Exxon stock went up during the next year to $72.58 per share, an increase of 15% for the year ($9.47). Your Jan 60 call would be in the money $12.58 per contract. Subtracting out the cost of the call or $8.40 would leave you with a profit of $4.18. Multiplying by $100 would give you a profit on the trade of $418.00 on initial capital of $840 for a gain of almost 50%.
If you had bought the stock outright, you would have $72,580.00 minus your cost of $63,110 or a gain of $9,470.00 or a gain of 15% on your initial capital.
If you had spent the entire $63,110.00 to buy LEAPS on Exxon you could have bought 75 contracts and had a total gain of $31,350.00 instead of the $9,470.00 from buying the shares outright. The LEAPS allow you to leverage your capital for higher gains.
Now if Exxon goes down or does not increase more than the cost of your premium, you would lose money on the transaction. With the LEAP, you are saying that you are fairly sure the stock is going to increase more than $8.40 per share during the next year. If you buy a call, the maximum you can lose is your $840 premium no matter how far the stock falls. If you bought the stock outright, you could lose $63,110.00 or your entire investment.
So, if you are fairly confident in a given company's performance and want to leverage your investment capital without borrowing money, consider a LEAPS
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