|HSL / Newsletter / Track Record / Tutorials|
1st, let's define LEAPS: Long-Term Equity AnticiPation Securities. A hideous name for a delightful security. LEAPS are in the options family— but they're not twins of regular options. To describe LEAPS as merely longer-term options is an oversimplification. But we're getting ahead of ourselves. In any field of study, there's jargon to be learned. Many investors get very confused by options jargon & understandably so. We'll make this as painless as possible & keep the terms to a minimum. Let's start at the beginning.
What is an option? An option is the right (but not the obligation) to buy or sell a fixed amount of a specific underlying security at a fixed price before its specified expiration date. There are 2 types of options. An option which gives the right to buy is a call option. To sell: a put option. Think of it this way, a call option allows you to "call" for the underlying security. A put option allows you to "put" the underlying security to someone.
Eg, 1 IBM December 110 call option. Typically, 1 option represents 100 shares of stock. The specific underlying security is IBM. The specified expiration date is Dec. In US exchange-traded "regular" options, the 3rd Friday of the month is the last trading day & Sat is the expiration day. The fixed price, called the strike price, is 110 or $110/share. The buyer/owner of the IBM Dec 110 call option has until December 19 ('97) to either sell the option in the open market or exercise the option (electing to buy 100 shares of IBM at $110/share—regardless of the current market price). Thus if IBM is at 135 on December 19, the buyer/owner of the option gets to buy ("call" for) 100 shares of a $135 stock (IBM) for $110/share. If IBM is trading at 110 or less, the call option expires worthless.
How can you protect your profits without eliminating all future upside potential? Buy LEAPS puts. To hedge all 2000 shares, you buy 20 puts. KO was at 70 in mid-July (it never went any higher & hit a low of 55 on September 12). To completely hedge any decline you buy the 70 strike price. You buy Jan '99 options to be "insured" for the next 18 months. (All US equity LEAPS expire in January). See how you meld your LEAPS selection with your expectations & goals? The average price for KO '99 70 LEAPS puts for the week after our FB was 7.20.
Let's examine different scenarios: 1) KO continues to drop & in January '99 is at 40. You can sell your LEAPS puts for 30 each (strike price: 70 - mkt price: 40 = +30), exercise your puts, selling your shares at 70, or some of both. If you sell the LEAPS, actual profit is $30 X 100 (# of shares represented by each LEAPS option) X 20 options = $60,000 (minus commissions). How'd you do? While KO plummeted 43%, you lost only 9%: 70 - 7.20 (cost of puts). If you think KO won't go any lower, sell your puts & keep the stock; 2) KO rallies to 100 by January '99. The LEAPS expire worthless, but your KO shares are up 30pts for a 33% gain: 30 - 7.20 (cost of puts). LEAPS puts allowed you to stay in the game, give the tax man all he "deserves" & sleep at night. (This is lucky #13 in the series, Building Wealth the Harry Schultz Way).
Back to Tutorial Page To Subscribe