Options, often seen as tools for the "fast money" crowd, are not just for speculators anymore. If an option trader can correctly forecast a stock's price within a specific timeframe and buy the appropriate option, huge profits can be made in a few months. But if the prediction is wrong, then the same option could easily expire worthless, wiping out the original investment. However, options can also be useful for buy-and-hold investors. Since 1990, investors have been able to buy options with expiration dates from nine months to three years into the future. These options are known as long-term equity anticipation securities (LEAPs) options. Read on to learn more about these options and whether they'll work in your portfolio.(To learn about options, see Options Basics Tutorial.)

Buying LEAPs
Investors can purchase a LEAP call option contract instead of shares of stock in order to get similar long-term investment benefits with less capital outlay. Substituting a financial derivative for a stock is known as a "stock replacement strategy", and is used to improve overall capital efficiency.

Rolled LEAPs
The biggest problem with options for the buy-and-hold investor is the short-term nature of the security. Even LEAP options, with expirations of more than a year, may be too short for the most ardent buy-and-hold investor.

However, a LEAP option can be replaced by another LEAP with a later expiry. For example, a two-year LEAP call could be held for a single year and then sold and replaced by another two-year option. This could be done for many years, regardless of whether the price of the underlying security goes up or down, making options a viable choice for buy-and-hold investors.

Selling older LEAPS and purchasing new LEAP calls in this manner is called the "option roll forward", or sometimes just, "the roll". An investor makes regular small cash outlays to maintain a large leveraged investment position for a long period of time.

Rolling an option forward is inexpensive because the investor is selling a similar option with similar characteristics at the same time. However, predicting the exact cost is impossible because option pricing depends on factors such as volatility, interest rates and dividend yield, which can never be precisely forecasted. Using the spread between a two-year and one-year option of the underlying security at the same strike price is a reasonable proxy. (To keep reading on this subject, see The Four Advantages Of Options, Alternatives To Closing Below Intrinsic Value and Reducing Risk With Options.)

Using LEAP calls, like any stock replacement strategy, is most cost-effective for securities with low volatility, such as index ETFs, sector ETFs or large-cap financials, and there's always a tradeoff between how much cash is put down initially and the cost of capital for the option.

An at the money option on a low volatility stock or ETF is generally very inexpensive, while an at the money option on a high volatility stock will be significantly more expensive.

Leverage Ratio and Volatility
At the money LEAP call options initially have higher leverage and volatility. Minor changes in the market price of the underlying security can result in high percentage changes in the price of the option and the value may fluctuate by 5% on a typical day. The investor should be prepared for this volatility. (To read more about leverage, see Margin Trading and What is the difference between leverage and margin?)

Over time, as the underlying security appreciates and the call option builds equity, the option loses most of its leverage and becomes much less volatile. Given multi-year holding periods, the results of the investment are relatively predictable using statistics and averages.

Note that a $1 increase in the underlying security will not immediately result in a full $1 increase in the LEAP call price. Because options have delta, they receive some appreciation immediately, and then accumulate the remainder as they get closer to expiry. This also makes them more suited for investors with longer holding periods. (Keep reading about delta in Gamma-Delta Neutral Option Spreads, Getting To Know The "Greeks" and Going Beyond Simple Delta: Understanding Position Delta.)

Example
In this example, we've calculated the implied interest rate and expected return on an at the money option on SPY, the S&P 500 Index Fund tracker ETF. We've assumed annual appreciation of 8% before dividends and will hold the option for five years.

Stock
Ticker	SPY
Price	143.81
5 year appreciation	+8% (before dividends)
5 year target price	211.30

 

LEAP Call option
Ticker	CYYLP.X
Price	31.60
Strike	120
Expiry	12/2008
Initial Delta	0.938
Cost of Capital	3.9% before dividends
Roll Forward	4.10, paid three times
Roll Forward %	3.4%, before dividends
5 year target price	91.30
5 year appreciation	+17.2%

Discounted cash flow calculations can be used to determine both the cost of capital and the expected appreciation.

The annual roll forward cost is unknown, but we'll use the cost difference between a December 2007 option and a December 2008 option at the same strike price as a proxy. It could go up or down next year, but over time it's expected to decline. The investor will pay the roll forward cost three times in order to extend the two-year option to a five-year holding period.

Note that in the above example, we excluded dividends. Option holders don't receive dividends, but they do benefit from lower option prices in order to account for the expected future dividend payments. When calculating expected returns for any LEAP, be consistent and either include or exclude dividends from both the cost of capital and the expected appreciation.

Summary
Most buy-and-hold investors and index investors are not aware that LEAP calls can be used as a source of investment debt. Using LEAP call options is more complex than purchasing stock on margin, but the rewards can be a lower cost of capital, higher leverage and no risk of margin calls.

LEAP call options may be purchased and then rolled over for many years, which allows the underlying security to continue to compound as the investor pays the roll forward costs. If the option is deep-in-the-money and the underlying security has low volatility, then the cost of capital will be low.

LEAP calls can give investors the ability to construct long-term portfolios of stocks or index ETFs and thereby control larger investments with less capital. In the above example, an investor could control a $143,810 index portfolio for a $31,600 initial payment.

Of course, it's always important to plan purchases, sales and future roll forward costs carefully, as exiting a large leveraged investment during a downturn will most likely lead to significant losses. Despite the fact that many option buyers are short-term hedgers or speculators, an argument could be made that leveraged investments are only appropriate for investors with very long horizons.

To read more about LEAPS, see Using LEAPS In A Covered Call Write and Trading A Stock Versus Stock Options - Part 1.

by Tristan Yates, (Contact Author | Biography)

Tristan Yates writes articles on index investing, options strategies, and leveraged portfolio management for Investopedia and Futures And Options Trader and distributed through Yahoo! Finance, Forbes, Kiplinger, and MSN Money, and his research on leveraged ETFs has been cited by the Wall Street Journal. He is the author of Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance. Yates has an MBA from INSEAD, a leading international business school, started his career managing risk for the $550B GNMA portfolio and helped lead the $1.1 Trillon securities restatement at Fannie Mae.