LEAPS is an acronym for Long-term Equity AnticiPation Securities. LEAPS are options, either calls or puts, that are available on many stocks and indices, and can be purchased or sold. Because they are options, they are denominated in strike prices, and have expiration dates. In the case of LEAPS, those expiration dates are typically two or sometimes three years away.
One of the benefits of LEAPS is that with the increased time to expiration, those options are not subject to as much volatility as nearer-term options. You can therefore buy or sell LEAPS and not have to monitor them as closely as their nearer-term counterparts. The tradeoff, however, is that LEAPS are generally more costly in dollar terms, yet still much less costly than investing in the underlying index or stock.
Suppose you are feeling bullish about a sector, say, the energy sector, and wish to take a position in ExxonMobil (XOM). One thousand shares of stock of XOM at $80.85 would cost $80,850.00. However, a deep-in-the-money $60 strike call option expiring in January 2013 costs only $23.85, for $23,850.00. This deep-in-the-money call option is almost all intrinsic value. With XOM’s closing price of $80.85, the $60 LEAP option costs $23.85, which represents only $3.85 of time value ($80.85-$60.00+$23.85). Time value is the speculative portion of an option. By purchasing the $60 strike LEAP, you are purchasing almost all intrinsic value of the underlying stock for a fraction of the price, and can deploy the remaining cash elsewhere.
If you own some LEAPS and wish to protect them, one alternative is to create a bull call spread by selling a higher-strike call against them to defray some of their cost. Since you own the $60 strike call LEAPS, you may sell any strike price LEAPS against it, or even create calendar spreads.
To create a bull call spread against your LEAPS $60 calls, you may sell the 2013 $80 strike LEAPS for $9.60, or $9,600.00. You have thus created a $20 spread for a debit (cost) of $14.25. If XOM closes anywhere above $80 by January 2013, the spread will increase in value and produce a profit of $20-$14.25=$5.75, or 40.35%.
To create calendar spreads against your LEAPS $60 calls, you may sell the July 2011 $85 calls for $2.18 or $2,180.00. This creates a $25 spread from the $60 LEAPS and the short-term covering calls of $85. You have thus reduced the cost of your LEAPS by $2.18, or 2.7%, and are net out of pocket $21,670.00. If XOM closes below $85 by the July 2011 expiration, you may simply repeat this process with subsequent months, and continue to reduce the cost of your LEAPS. If XOM rallies and closes above $85 by the July 2011 expiration, you may have to exercise your $60 LEAPS in order to deliver the stock, and your profit would be $3,330.00, or 15.36% for three months.