LEAPs are traded just like shorter-term stock options. The only difference is the expiration date, which can be as far as three years. Because the price of the underlying stock can change a lot over such a long time frame, LEAPs are expensive to purchase and risky to sell.

For traders who do not enjoy micromanaging a portfolio, LEAPs are a good way to hedge a position. By purchasing a January 2010 put on one of your underlyings, you are ensured a hedge until then. If you purchase shorter term puts then they will expire worthless each period assuming your underlying does not decrease in price enough to necessitate exercising the put. Allowing a hedge to expire is like letting an insurance policy lapse, and if you forget to roll your hedge each expiry, you may be left at risk.

Also, buying a new put each period might be more expensive than buying one put that will hedge you for up to three years. As the price and volatility of the underlying and the underlying change, options can become very expensive to purchase. Since options are often bought and sold as investments or trades in their own right, their price may increase just because buying a certain option on a certain stock has been touted as a “hot” trade. An out of they money put may become overvalued for no fundamental reason. Hence, by purchasing a LEAP now, you are protecting yourself from the vagaries of options prices.

I recently purchased a LEAP. It is a call on a small tech stock. The company has a drug compound in the pipeline and will soon be completing its studies and filing with the FDA. I believe the stock is appropriately valued at around 2.3 now, but I purchased a 2.5 call for January of 2009. The call was embarrassingly cheap, so the risk is trivial. A market rally or some good news from the company could easily send that call into the money.

Normally, I do not buy options. I sell options and make fun of those who buy them. However, I am a staunch advocate of keeping an open mind with regard to trades. There are many types of opportunities, so it makes no sense to define yourself exclusively as a particular “type” of trader. When the option is cheap, near the money, and has plenty of time before expiry, it may be a good speculation. After all, the stock does not have to stay at a price that puts your option in the money. In fact, the option does not have to be in the money! The only thing you need when you are long an option is for investors to think it might go in the money. When investors start to believe the option will have value, they start buying, the price goes up, and you can either sell or wait in the hope of more profit. (Beware time decay!) At the very least, buying a cheap, far option is a trade with defined risk, since the most you can lose is the option premium that you paid.

Most trades of the type described above will lose, but those that pay off have the potential to make a large return. I prefer selling options because most trades win, but of course I acknowledge that it is possible to “lose big”, and that option sellers need to be prepared to lose the proceeds of several good trades on one bad one. No matter which philosophy you choose, there will be risks and rewards, and it doesn’t hurt to have some variety in your trading. With that in mind, I think it’s best to have long LEAPs and short options otherwise.

by Raven Lebeau