More Investors LEAP Into the Options Fray

Paul Reid, a Boston-based columnist, thinks that anyone who invests a big chunk of assets in long-term stock options, better known as LEAPS, is jumping off “a precipice of frightening proportions.”

But Ruth Mages, a Chicago-area business owner, loves them. They give her more time to be right about her stock guesses, and one such pick recently netted her a 300% profit.

Such are the differing opinions about one of the nation’s newest and hottest financial products: Long-term Equity Anticipation Securities, or LEAPS.

LEAPS, created by the Chicago Board Options Exchange in October, 1990, are one of the fastest-growing financial products around.

More than 1.5 million LEAPS contracts were sold in 1992, compared with 626,642 such contracts in the previous year--a 147% jump. And volume during the first seven months of 1993 indicates that the product’s sales could double again this year too.

LEAPS still account for just a fraction of the total options market--they make up about 5.3% of CBOE equity option volume--but their growth has been phenomenal, particularly for a fledgling financial product, says CBOE spokesman Stan Latta.

That growth is particularly noteworthy in today’s option environment, he adds. During the same period, the number of ordinary equity option contracts sold has declined steadily. There were 43.4 million equity option contracts sold in 1992, compared to 48.3 million during 1990, Latta says. The market for all equity options has soared in the last three months, however. Now it looks as if the options market--as well as the market for LEAPS--will reach record heights in 1993.

What makes LEAPS so popular?

They’re similar to ordinary stock options that give investors the right, but not the obligation, to buy specific company shares at a set price in the future. But where ordinary stock options expire within a few months, LEAPS last as long as two or three years.

That’s made them a hit with investors who are uncomfortable with the short time horizons on ordinary stock options, but who still like the idea of winning the lottery. Hitting it right with stock options is similar to winning a bet, because the payoffs can be stunning compared to the amount of money invested.

Consider two investors, who both expect the stock of XYZ Co. to soar. One investor buys 100 shares of XYZ at $50 a share--a $5,000 investment. The other buys one option contract, which gives him the right to buy 100 shares at $50 each three months from now. His contract costs $2 a share, or $200.

If within a month, XYZ announces record earnings and the stock price jumps to $55, the price of the option is likely to rise to about $6. In other words, the investor who bought the stock gets a paper profit of $5 per share, or 10%. Meanwhile, the option buyer has tripled his money.

Such returns can be compelling, but there’s also a rather compelling downside to buying stock options. Put simply, most option contracts expire worthless either because the investor was wrong about the direction of the stock or about the time it would take the stock to get there.

Worse still, the stock price doesn’t have to fall and the option doesn’t have to expire for option investors to lose money. If absolutely nothing happens, the option declines in value simply because of the passage of time.

Indeed, when the price of the underlying stock remains constant, the price curve on most options looks something like a “rock rolling downhill,” experts note. That’s because there’s less time for the bet to turn out right. And in the options market, there’s no question that time is money.

That, in a nutshell, is the whole draw of LEAPS: They give investors more time to be right.

“It’s like Vince Lombardi used to say, ‘We didn’t lose the game. We ran out of time,’ ” says Barry Davis, first vice president of Shearson Lehman Bros. in Chicago. “LEAPS give you a few more quarters in the game.”

But you pay for that extra time.

LEAPS typically sell for two or three times the price of a short-term option. The price, like the price of an option, is determined by how much time is left on the contract, the company’s prospects and its stock price volatility. Options on volatile stocks--those that exhibit large price swings--are generally more costly than on stable stocks, since there’s a better chance the option will be exercisable.

The extra time also means that LEAPS prices don’t start to erode dramatically until they’re more than a year old. Then, when there are only seven or eight months left on the contract and the underlying stock isn’t moving, LEAPS prices also start to “fall off a cliff.”

Those who haven’t taken their profits--or cut their losses--before then can suffer the same problems as buyers of ordinary options.

Says the cynical Reid: “The only advantage to LEAPS is you have a longer period of time to lose your money.”

Look Before You LEAP

You want to get into LEAPS? Experts say you can boost your chances of making a profit--or limiting your losses--if you follow a few guidelines.

* Determine your goals. You should have a good idea of where you expect the price of the underlying stock to go, which will also determine the price of the LEAPS. Write down that goal, and sell your LEAPS when you hit it. Why? Option prices are volatile. If you keep waiting for a bigger score, chances are you’ll strike out.

* Cut your losses. Before you start, figure out at what point you’ll cut your losses if the stock doesn’t perform as you expected. Your goal can be related to time or price. For instance, you may decide you’ll sell within a year if the stock price hasn’t moved. Or you may decide to sell once you’ve lost 20% of your original investment.

* Watch closely. Investments in LEAPS, as in other types of options, must be monitored carefully. If you don’t have a broker who watches your investments for you, you need to watch trading prices daily, or at least weekly.

* Don’t invest the rent money. All option investments are speculative, so put only a small portion of your total portfolio--usually less than 5%--in any type of options. And if this is money you can’t afford to lose, you can’t afford to invest it in options.

Growing by LEAPS and Bounds

While the market for ordinary equity options declined, sales of LEAPS--options with durations of more than a year--soared. Options of all types have surged in the past three months, however. Option experts now believe that both LEAPS and ordinary equity options will stage a record year.

Short-term LEAPS Year options sold sold 1990 48,269,881 216,521 1991 44,629,659 625,642 1992 43,420,518 1,547,717 1993* 29,295,796 1,542,067

* partial year, January through July

Source: Chicago Board Options Exchange