The Discreet Charm of Long-dated Equity Options

LEAPS investors figure: "Why buy three-month options for a long-term hedge?"

By John Thackray

Five years ago last month LEAPS (Long-Term Equity Anticipation Securities) were first traded on the CBOE. The birthing fanfare proclaimed that LEAPS could be the magic bullet that would attract a significant population of institutional and retail customers to equity options. At the time exchanges were pretty desperate for innovation, since options trading volume had never recovered from the October '87 crash.

LEAPS were indeed different. Here at last was an option that didn't have the usual three-month shelf life and didn't require enormous trading skills and focus. LEAPS, which run up to three years, can be used by investors to more clearly exploit their long-term view of an equity's fundamentals, positive or negative. An investor wanting to write a one-year call with three-month options would have to go to the market four times. Each time he rolled the contract, prices and conditions would be different, and each time there would be new commissions to pay. Selling a one-year LEAPS call, by contrast, is an inexpensive no-brainer.

So how well have LEAPS lived up to their promise? Pretty well, thank you. "They have proved to be an enormously successful product," says Harrison Roth, first vice president, senior options strategist at Cowen & Co. and author of LEAPS: What They Are and How To Use Them for Profit & Protection (Irwin, 1994). The 14 original two-year calls listed on the CBOE have grown to a total of 188 LEAPS on five exchanges. More than 20 million LEAPS have been traded since their inception in 1985 - and more than 5 million in the first nine months of this year. The Pacific Stock Exchange, which specializes in high-tech options, saw trading volume and open interest surge by some two-thirds in the first half of the year. At the CBOE, which lists the popular LEAPS on the S&P 500 and S&P 100, six-month volume was up 25 percent. (See chart.)

Rent-a-stock

Most of the volume surge is the work of institutions who use LEAPS for portfolio enhancements, hedging strategies and arbitrage plays. LEAPS are most commonly used for call buying, as an alternative to holding the underlying stock or index basket. "More and more institutional salespeople are comfortable with long-dated options and know how to explain the advantages of the longer time factor to their clients," says Emmett Harty, president of the Parallax Group. The CBOE has been the most aggressive with LEAPS outreach efforts, with advertisements (the pitch: WHY BUY A STOCK WHEN YOU CAN LEASE IT?), 800 info numbers and investor seminars. "LEAPS have brought new users into the franchise," says Bruce Goldberg, vice president retail marketing at the CBOE. "Their growth has been incremental, not from cannibalizing short-term options."

The new LEAPS users have helped boost the efficiency of the entire equity options market, since the trading in LEAPS contracts inevitably helps investors value the shorter-term contracts. "If an investor can see price discovery, and understand the dynamics of pricing, it adds to his comfort level," Harty says. "Investors in telephone options can be more comfortable when they can see a continuing market in telephone LEAPS."

LEAPS are American-style options with one-, two- and three-year maturities. In their last nine months of life, they are fungible into the conventional short-term options. There are three strike prices upon issuance: in-, at- or out-of-the-money. For a call, the in-the-money is 20 percent away from the money, with an out-of-the-money strike roughly 25 percent away. The strikes are the same in the far less popular LEAPS puts.

Close trackers

For certain stocks, LEAPS can function as a efficient surrogate for the underlying stock. "A LEAPS call can be like buying the stock on margin, without having to pay margin interest," says Cowen's Roth. Deep in-the-money LEAPS often behave in lockstep with the underlying equity. For instance, a number of LEAPS were created in technology companies in 1995, when the sector was far from popular. "They are so deep in-the-money that they trade an eighth for an eighth with the common," gushes one trader. "If you take the cost of margin account requirements into account, using a LEAPS is just as efficient as going long or short the stock."

Most LEAPS, however, do not trade so efficiently. On any market day there may be some pricing and/or liquidity headaches on more than a handful. "LEAPS investors are either buying or selling volatility," notes one exchange official. "On balance they seem to favor buying it, and this tends to create imbalance. The result is that pricing is on the higher side of what would be normal. Markets are wider than the additional time term of LEAPS alone would justify." For proof one need only look at the bid-asked spreads on the S&P 500 LEAPS, which tend to be around a dollar, versus an eighth to a quarter in the hyper-efficient short-term options market.

Long-term bargain

In spite of this, LEAPS can still be a bargain if the investor's intent is to create a long-term portfolio hedge that would normally require rolling over a series of three-month contracts. Says Jack Hansen, director of equity investments for the Clifton Group: "LEAPS permit us to have some perfect long-term hedges on alternative cash arbitrage positions - something we could not accomplish with short-term traded vehicles."

Clifton also uses LEAPS to pursue volatility-based trading strategies. The firm regularly buys or sells volatility on individual stocks and the entire market. When volatilities are high, the firm likes to sell as many long-dated positions as possible. LEAPS permit Clifton to make a long-term lock of its position, which might face execution obstacles with roll-overs in the short-term market. "If the strategy is right, we can profit more with a two-year option than one that lasts only two months," says Hansen.

Another tactic deployed by Hansen and many others is to use LEAPS as an arbitrage that reconstitutes the common by combining them with PERCS (Preferred/Preference Equity Redemption Shares), or ELKS (Equity Linked Securities). PERCS are a kind of preferred stock issued by corporations that place a cap on potential capital gains in return for yield enhancement. ELKS, on the other hand, are dividend-paying notes issued by brokerage houses without principal protection. "In the last few months there were many times when you could have bought a combination of Microsoft ELKS and LEAPS cheaper than the common," notes Parallax Group's Harty. Using LEAPS like this in combinations that create a synthetic common is also popular in takeover deals.

Slow movers

Individual LEAPS vary greatly as to liquidity. At the CBOE last year, LEAPS on Teléfonos de México, Citicorp, Merck, Monsanto and GM were responsible for about a quarter of total contract volume on individual company LEAPS. Most of the LEAPS on other exchanges were half comatose. A dozen on the CBOE, for example, had an average daily volume of less than 50 contracts during the year. "There is a very liquid market in the top five LEAPS on our exchange in part because of the skills of market makers in maintaining tight markets," says a source at the Pacific Stock Exchange. "But in some other stocks our market makers have a concern that they may be able to get into a position, but how will the market treat them on the way out?" Another exchange official concedes: "If you came to this floor looking for a bid in size on a two-and-a-half year LEAPS, you might have trouble."

One of the most popular LEAPS strategies involves buying the underlying stock and then selling a call, effectively selling off the upside in exchange for the call premium. The American Stock Exchange has been been working on a release of a pre-packaged buy-write companion to LEAPS called BOUNDs (Buy-write Option-UNitary Derivatives). Added together LEAPS and BOUNDs will correspond to the price of the underlying equity. It expects to trade the first BOUNDs within months, each listed at-the-money and with the same expiration dates and strike prices as the LEAPS. The attraction of BOUNDs, the Amex hopes, is that "now investors will be able to execute a buy-write in a single transaction, instead of two transactions that may be difficult to coordinate," says Nathan Most, senior vice president at the Amex. "BOUNDs are very interesting, and should help in the marketing, because a substantial number of LEAPS are used in these types of combinations."

What's the likeliest scenario for LEAPS? Clearly they rate as one of the most successful innovations of the last decade - particularly index LEAPS. Many sources feel that their future is very bright indeed. "My belief is that the strong growth of LEAPS trading and therefore growth in liquidity that we've seen is nothing compared to what will happen going forward," says the Parallax Group's Harty.