The stock market offers plenty of opportunity for profitable investing, but all potential rewards come with a certain amount of risk. When it comes to buying individual stocks, your potential reward is theoretically unlimited, since there is no limit to how high a stock's price might rise. Your risk is limited to 100 percent of your investment. Long-dated call options also offer potentially unlimited reward and carry a risk of 100 percent of your investment, but allow you to control the same amount of stock for a substantially lower investment.
A call option is a financial contract that gives the holder the right, but not the obligation, to buy the underlying stock at a set price, known as the strike price, for a set period of time. Each call option controls 100 shares of the underlying stock. Once the call option reaches the end of its contract period, referred to as the expiration date, it becomes worthless and ceases to exist. A call option's sale price is referred to as the premium. You can buy or sell call options. Selling a call option is referred to as writing the option.
Call options have two kinds of value: intrinsic value and time value. The intrinsic value is the difference between the option's strike price and the underlying security's current market price. For example, if XYZ stock is selling for $40 per share, a call option on XYZ stock with a strike price of $35 would have an intrinsic value of $5, since the holder could exercise the option, purchase the stock at $35 and sell it immediately for $40, thereby realizing a profit of $5 per share. If the underlying security's market price is below the strike price, the call option has an intrinsic value of $0. A call option's time value is the difference between the option's current market premium and its intrinsic value. A call option's time value erodes as it approaches its expiration date. Long-dated call options have a greater amount of time than standard call options for market conditions to improve for your benefit, so they tend to have greater time value.
Long-Term Equity AnticiPation Securities is the technical term for long-dated options. Standard options have an expiration date of one year or less. LEAPs have an expiration that can extend for up to two years and eight months, according to the Options Industry Council.
Long-dated call options provide an alternative to stock ownership. You can benefit from any increase in the price of the underlying stock for the price of the premium rather than the substantially higher price of the stock. Long-dated call options also limit your risk. If the market price of the underlying security drops precipitously, your loss is limited to the amount you paid for the premium. Long-dated call options are traded on major securities exchanges, which provides the added benefit of a ready market. You don't have to exercise the option. Instead, you can close the option out by selling it at the current market price.
Long-dated call options allow you to control the underlying stock for an extended period of time, but if you don't exercise the option, at some point it will expire, become worthless and cease to exist. Owning an option on the underlying stock does not give you voting rights in the company or the right to any dividends that are paid on the stock.
- Options Industry Council: What is an Option?
- Options Industry Council: LEAPS® - Options for the Long Term
- Options Industry Council: How LEAPS® Work
- Options Industry Council: LEAPS® Strategies
- CBOE: Long-term Equity AnticiPation Securities (LEAPS) at CBOE
- CBOE: Buying Equity LEAPS Calls To Anticipate A Rally
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.