LEAPs: Here's a Chance to Hop over Risk

These equity contracts can offer a safer way to edge into the market

With Wall Street brooding over war and recession, it's hard to make the case that a bull market is right around the corner. Instead of waiting on the sidelines--a risky move, since share prices often spike before most realize a recovery is under way--consider investing in Long-term Equity Anticipation Securities, better known as LEAPs. They're long-term options that allow you to bet on a stock's, or the entire market's, revival down the road in 2003 or 2004. "They let time work for you, which is important, since it will take time to recover," says Michael Schwartz, chief options strategist at CIBC Oppenheimer.

Sure, options are derivatives and can be risky when used to place big bets. But options can also be part of a low-risk investment strategy. For instance, with LEAPS, you can lock in today's beaten-down prices and profit from a rebound. If you're wrong, you stand to lose only a fraction of what you would have if you had purchased stock outright. Moreover, because options cost much less than their underlying shares, you can reduce the portion of your savings tied up in stocks, while maintaining the same level of exposure to the equity markets. Buying options can be "more conservative than owning a stock," says Kyle Graham, instructor at the Options Institute, the education arm of the Chicago Board Options Exchange.

LEAPs give you plenty of, well, options. You can trade them on about 340 stocks. Or you can use LEAPs to make plays on the popular market indexes, such as the Dow Jones industrial average, the Standard & Poor's 500-stock index, or the Nasdaq 100. Moreover, while prices on short-term options can jump sharply from day to day, LEAPs prices typically move gradually until about three months before expiration, when they behave like short-term options. LEAPs allow you to "weather some of the stock market's volatility without having to watch your positions constantly," says Joseph Sunderman, manager of research at Schaeffer's Investment Research, an options firm based in Cincinatti.

Although these options have expiration dates, you don't have to hold them until then. If after a while it looks as if you were wrong about a stock's prospects, you can sell the option. You won't make much--how much value remains depends on how far the stock has moved and how much time is left until expiration. But you will likely recoup some of your losses.

Another advantage to LEAPs is their tax treatment. LEAPs generally offer two expiration dates, with the current contracts lapsing in January, 2003, and January, 2004. (The first group of 2005 LEAPs is expected to appear in May, 2002.) Unlike short-term options, LEAPs held for a year and a day or longer should qualify for the lower capital-gains tax rate reserved for long-term investments, says Bill Ryan, manager of the Options Industry Council Call Center, which serves brokers and individual investors. However, if instead of selling your options you exercise them, you must hold onto the stock for another year before it can qualify for long-term capital gains tax treatment, Ryan adds. Since the rules can be complex, consult a tax expert.

As is the case with the more familiar short-term options, LEAPs come in two varieties--calls and puts. If you buy a call, you've got the right, but not the obligation, to purchase a stock at a specified price until an agreed-upon expiration date. Sell a call, and you may be asked to sell your stock at the pre-agreed price.

Puts are just the opposite. If you buy a put, you've got the right, but not obligation, to sell your shares at a specific price. If you sell a put, you've agreed to buy stock at a certain price from the owner of the put.

Which strategy makes sense for you depends on your outlook for a stock and the trade-off between risk and return that is acceptable to you. Web sites, such as that run by the Chicago Board Options Exchange (www.cboe.com), can help you calculate potential returns. Options prices are available there and also at BusinessWeek Online.

You don't have to be a heavy hitter to trade options. True, it's more economical to place big trades, because brokerage commissions are typically about $20 for the first contract and then decline sharply. But brokerages often require those who buy LEAPs puts and calls, or sell calls on stock they already own, to have an account worth at least $5,000 and a net worth of $25,000.

What follows is a description of how LEAPs can be used in strategies that reflect bullish, neutral, and bearish outlooks on the market.

LOOKING UP. One way to bet on a recovery in 2003 or 2004 is to buy LEAPs calls. Say you have your eye on Cisco Systems (CSCO ). Instead of buying the stock at its Oct. 15 price of about $16, you can purchase a LEAPs call that gives you the right to buy Cisco at a specific price in the future. One frequently traded LEAPs call entitles its owner to buy Cisco at $15 per share by January, 2003. On Oct. 15, the premium--or price--on that contract was $5.10, which really means $510, since each call option typically covers 100 shares. If Cisco rises--say, to $25--you would buy the stock at $15 and reap a profit by selling it at $25. However, should Cisco fall below $15, your losses are capped at the $5.10 premium.

If you are a conservative investor, a good way to bet on the market while maintaining a safety net is to combine LEAPs calls with ultrasafe investments, such as money-market funds or U.S. Treasury bills. To see how this works, consider a woman who wants to buy 1,000 shares of Cisco at $16. Rather than shell out $16,000 for the stock, she can control the same 1,000 shares with 10 LEAPs call contracts, giving her the right to buy Cisco at $15. Each contract costs $510, so the total outlay is $5,100.

The woman can then deposit the remaining $10,900 she wants to invest into a money-market fund. Say the stock rises to $30. The investor would exercise the option to buy at $15, using the money-market account to help fund the purchase. But if the stock falls, the losses are capped at $5,100. Actually, it's a little bit less because "the loss will be reduced a bit by the interest earned on the money market account," says James Bittman, senior instructor at the Options Institute.

NERVOUS. Another way to gain some protection while preserving your upside potential is to buy LEAPs put options on stock you already own or are buying. If you buy a put, you have the right to sell your stock at a pre-agreed price. Say, for example, you think Cisco Systems has better long-term prospects than its $16 share price suggests. You can always buy the stock. But if you are nervous about the tech sector, you might protect your investment with a $17.50 LEAPs put. With this option, you are guaranteed to be able to sell your Cisco at $17.50--and so will be able to sleep at night if the stock slides. But if Cisco soars, you can keep your stock and participate in the rally.

Before settling on an expiration date or strike price, consider your outlook for the stock. For example, if you think Cisco will hit $25 by January, 2003, why pay a hefty $5 premium for an option that locks in a $17.50 sale price? You'd be better off paying a smaller premium of $3.50 for a $15 sale price. Sure, you have less protection against a sell-off. But if Cisco rallies, the lower premium positions you to share in more of the profits. Generally, the more an option protects, the stingier its payoff in a rising market.

If you're particularly bearish on a stock, you can just buy the put without owning any shares. Say, for example, you pay $5--actually $500--for the right to sell 100 shares of Cisco at $17.50. If the stock falls, the value of your put will rise--let's say, to $5.50--as more investors chase after a guaranteed $17.50 exit price. In this example, you can sell your put for an immediate profit of 50 cents a share. Of course, if the stock rises, your put will lose value. But your losses are capped at the $500 you paid for the LEAPs.

Some traders use another tactic, known as a short sale, to bet on a downturn. Selling short involves selling borrowed shares today in the hope that when it comes time to replace them, the price will be lower. But that's more risky than buying puts because it leaves you exposed to unlimited losses if the stock soars.

TREADING WATER. If you expect a stock you own to tread water, a good way to make some money while holding it is to sell a call. Say you purchased Cisco at $16. If you sell a call giving someone the right to buy your stock at $17.50 by January, 2003, you will immediately pocket a $3.90 premium. Of course, if the stock rises above $17.50, you will be forced to sell your shares for the bargain price of $17.50. But that's not all bad, since you will realize a $1.50 gain on the sale. And when combined with the $3.90 premium, this gives you a 34% return on your $16 investment. Cisco would have to rally to $21.40 for you to receive the same return on a stock purchase.

If Cisco falls below $17.50, no one will want to buy it at $17.50. So the call will expire, worthless, and you will keep your stock. Still, the call's premium gives you some protection. In fact, Cisco could decline by as much as $3.90--to $12.10, from your $16 purchase price--and you would not lose a dime.

Among the Cisco LEAPs calls with the highest trading volumes on Oct. 15 were those with strike prices of $15, $17.50, and $20. Since the $15 call is already valuable--who wouldn't want to buy a $16 stock for $15?--it will net you the highest premium. But if you sell this contract, you run the greatest risk of being forced to sell your shares. So don't write calls on a stock unless you would not mind selling it at the agreed-upon price.

LEAPs require you to master a new set of rules and calculations beyond what it takes to invest in stocks. But they give conservative investors a tool to bet on a stock market recovery down the road--without betting the ranch. Now that an economic recovery has been delayed by the events of September 11, you can't afford to ignore tools for placing long-term bets.

By Anne Tergesen

Before it's here, it's on the Bloomberg Terminal.