Long-Term Options- Introduction

Long-Term Options


Instead, the purpose of this is to highlight the fact that option premiums in general do not reflect the expected long-term growth rate of the underlying equities and to explain an investment strategy that can be used to take maximum advantage of this phenomenon. As I mentioned before, my own interest in this subject stems from the fact that I could no longer contribute additional funds to my retirement plan. As a long-term investor in the market, I had assembled a stock portfolio over many years, and I simply did not wish to raise cash by selling any of my winners. My few losers and laggards had long since been disposed of and the proceeds used to buy more shares of my better-performing stocks. I'm not a short-term, in-and-out investor, but I wanted to keep buying.

Options seemed the way to go, but as with stocks, purchasing calls requires money. What's more, options can only be paid for in cash, so going on margin and borrowing the funds from my broker was out of the question. My next thought was, if I'm going to raise cash, why not sell covered calls on my portfolio? I tried this a few times and promptly had some of my stocks called away from me when their share prices sharply increased as a result of takeover rumors or positive earnings surprises. I wasn't too happy about having to buy back shares using the little cash I had remaining to cover the gap between the exercise price received and the higher repurchase price. So much for covered calls.

By process of elimination, the only strategy remaining was selling puts. This method, you will recall, generates up-front money through the premiums received. Option premiums must be paid on the next business day and are available for reinvestment even faster than proceeds from the sale of stock (which settle within three business days). And because these funds represent premiums paid, not dollars borrowed, they are yours to keep. However, as the fine print in most travel ads states, "certain restrictions apply." Premiums have to stay in your account in case they are needed later in the event of assignment. But because they are in your account, you can use them to acquire additional equities. 

The problem with this approach, I soon discovered, is that applying it to standard options does not bring in much money, especially in relation to the risk assumed in potentially having the underlying stock assigned to you. You can certainly sell a put whose exercise price is well below the current stock price, thereby minimizing the risk of assignment, but doing this brings in a very small premium. A larger premium can be generated by selling a put with an exercise price much closer to or just below the current price, but this can entail significant risk of assignment. Substantial premiums seen on out-of-the-money* puts typically indicate highly volatile stocks or instances where the market (probably correctly) anticipates a sharp drop in the value of the underlying equity—situations that had no appeal to me whatsoever.

And if all that isn't enough, there is also the fact that dealing in standard options, with their quickly changing market values, typically requires substantial, if not full-time, commitment to the task. Most option traders I've met have had little time for anything else during their working days and have often spent a good deal of their evenings and weekends conducting research into what trades to enter and when to cover and get out. This kind of nerve-wracking, nail-biting, glued-to-the-console environment is not what I wanted either. It then occurred to me that there was a solution to this dilemma.

There does exist a class of options whose premiums are relatively large, which bear less risk than standard options, and which, because the underlying equities are comparatively stable, do not have to be monitored with anywhere near the same intensity as standard options. What distinguishes this class of options is their long-term expiration date, which permits the market price of the underlying equity plenty of time to recover should the overall market, industry sector, or the company itself encounter a temporary downturn or adverse conditions. It occurred to me that by selling puts on stronger, well-endowed firms whose intermediate- and long-term prospects are above average, it might be possible to achieve high returns without incurring undue risk.


The class of options that fits this description was actually created by the Chicago Board Options Exchange in 1990. Because standard options expire at most eight months after their inception, the CBOE introduced a new product for investors wishing to hedge common stock positions over a much longer time horizon. These options, called LEAPS (Long-term Equity AnticiPation Securities), are long-term options on common stocks of companies that are listed on securities exchanges or that trade over the counter. LEAPS expire on the Saturday following the third Friday in the month of January approximately two and a half years from the date of the initial listing. 

They roll into and become standard options after the May, June, or July expiration date corresponding to the expiration cycle of the underlying security. In most other ways, LEAPS are identical to standard options. Strike price intervals for LEAPS follow the same rules as standard options (i.e., they are $2.50 when the stock price of the underlying equity is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200). As for standard options, strike prices for LEAPS are adjusted for splits, major stock dividends, recapitalizations, and spin-offs when and if they occur during the life of the option. 

Like standard options, equity LEAPS generally may be exercised on any business day before the expiration date. Margin requirements for LEAPS follow the same rules as standard options. Uncovered put or call writers must deposit 100 percent of the option proceeds plus 20 percent of the aggregate contract value (the current price of the underlying equity multiplied by $100) minus the amount, if any, by which the LEAP option is out of the money. The minimum margin is 100 percent of the option proceeds plus 10 percent of the aggregate contract value. 

LEAP Premiums

Option premiums in general vary directly with the remaining time to expiration. As a result of their longer lives, LEAPS have premiums that can be considerably greater than those of their standard option counterparts. Each entry in the table is the theoretical premium corresponding to the expiration time in months shown in column 1 and the stock volatility, ranging from a fairly low level of 0.15 to a fairly high level of 0.65. Intel's stock, for example, has a volatility of about 0.35, so when the stock price reaches $100, an at-the-money put option should command a premium of $829.60 ($8.296 × 100 shares) with six months to expiration and a premium of $1,313.40 ($13.314 × 100 shares) with 24 months to expiration.

That is, if the stock price and strike price are both $50, the corresponding per share premiums are exactly half the amounts shown. The first question people often ask is why the at-the-money call premiums are so much greater than the corresponding put premiums for the same time horizon and volatility level. Note, for example, that for a stock with a volatility of 0.35 and an expiration date 30 months away, the put premium is $14.035 per share versus $27.964 for the call premium. Is this difference due to general inflation and/or the expected growth rate in the underlying equity?

The answer is no. The reason the call premiums are greater is that option pricing models assume that stock prices are just as likely to increase by, say, 10 percent as they are to decrease by 10 percent on any given day. On a cumulative basis, there is therefore no limit to how high prices can go up over time, but there is a definite lower limit (zero) to how low prices can go. It is this possibility of unrestricted price movement upward versus restricted price movement downward that explains why calls are more expensive than puts.


There is another major advantage associated with LEAPS. Because of the inherently greater premium levels involved, the brokerage commissions charged are going to be a smaller percentage of the proceeds received. At a full-service firm, the brokerage commission to buy or sell a single option might be $45. In percentage terms, this amount is almost 12 percent of the premium for the one-month Intel option, but just 3.2 percent of the premium for the 30-month LEAP option. Commission costs per contract rapidly decrease at a full-service firm if more than one contract is involved and might range from $25 to $35 each for three contracts down to just $15 to $20 each for ten contracts.

At a discount broker's, the commission might be $20 each, but it is typically subject to a minimum fee of $40 and a maximum fee of $70 on transactions involving one to ten contracts. For online, deep-discount, and option-specialized brokers, the commission might be $15 each but is typically subject to a minimum fee of $35 and a maximum fee of $60 on transactions of one to ten contracts.

Table  European-Style At-the-Money Put Premiums as a Function of Time and Volatility

Although there can be significant differences in total commission costs between full-service brokers and other firms, I prefer to work with options-knowledgeable people at a full-service firm. I can readily do this because I am not a short-term investor, and the relatively small number of trades I do per year does not result in significant commissions in terms of absolute dollars. This is particularly true when one remembers that in selling options that subsequently expire worthless, only one commission is involved, not two.

Table  European-Style At-the-Money Call Premiums as a Function of Time and Volatility

LEAPS Available

LEAPS are currently traded on over 300 widely followed equities (as well as on numerous industry sector, domestic, and international indices). Shows the name of the underlying security, its stock symbol, the standard option symbol, the exchange code(s) showing where the option is traded, the options cycle governing when the LEAP option rolls over into a standard option, and the option symbol for the LEAPS expiring in the years 2001 and 2002. Omitted from the table are issues for which no new LEAPS will be listed as a result of mergers and acquisitions that have taken place.

Exchange Codes.

LEAPS are traded on one or more of four major exchanges,* as indicated by the following symbols:

A American Stock Exchange
C Chicago Board Options Exchange
P Pacific Stock Exchange
X Philadelphia Stock Exchange

Expiration Cycles.

These are the January, February, and March cycles that control how and when each LEAP option rolls over into a standard option. It is important to note that the trading symbol for a LEAP option will change when it does roll over and become a standard option, and quote requests, statements, trades, close-outs and exercise instructions should reflect this. In Table, the numerical codes used for the expiration cycles are:

1 January Sequential
2 February Sequential
3 March Sequential

The expiration cycle of a given class of options also tells you the specific month that the corresponding LEAP is due to open for trading. For example, Intel is cycle 1, so the next set of Intel LEAPS is supposed to open right after the May expiration. Boeing is cycle 2, so the next set of Boeing LEAPS is supposed to open right after the June expiration. And Pfizer is cycle 3, so the next set of Pfizer LEAPS is supposed to open right after the July expiration.

LEAP Symbols.

To facilitate trading, LEAPS are symbolized by a four- to six-character trading symbol made up of a root symbol designating the underlying equity, a single character designating the expiration month, and a single letter designating the strike price involved. Because LEAPS expire only in January, the code letter for the expiration month is always A for calls and M for puts. The root symbols for the underlying equity began with the letter V for the January 1999 LEAPS and the letter L for the January 2000 LEAPS, and begin with the letter Z for the January 2001 LEAPS and the letter W for the January 2002 LEAPS. This V/L/Z/W sequence of initial letters is repeated every four years, so the letter V will likely be assigned as the starting letter for the year 2003 LEAPS.

As each LEAP option rolls over into a standard option approximately a half year prior to expiration, the root symbol portion of the trading code is changed to that of the standard option. Because of conflicts that frequently arise with existing trading symbols of stocks and standard options, there is often no consistency in the designations of LEAP root symbols. Note too that although the LEAP root symbols are three letters long, in some instances they consist of just two letters. A dash indicates that there was no LEAP option offered for that year on a particular security, often because of a pending merger or acquisition.

It is frequently the case that as a result of a wide fluctuation in stock price (as well as mergers, acquisitions, and stock splits), there is going to be more than one LEAP root symbol for a given stock and expiration year. For example, the January 2001 LEAPS for Yahoo have the root YZY for strikes between $22.5 and $35; ZYH for strikes $37.50 through $85; ZGH for strikes $90 through $135; ZYO for strikes $150 through $200; and ZYM for strikes between $210 and $250. The only sure way to determine the correct root symbol for a given LEAP option series is to consult an online table showing the specific LEAPS available, such as the one maintained by the Chicago Board Options Exchange. Or you can call the CBOE directly at 800-OPTIONS (678-4667).

Position Limits.

Not shown in Table because of rapidly changing conditions is the maximum number of open contracts that are permitted on any option class. As opposed to stocks, whose outstanding shares often number in the hundreds of millions, the maximum number of open option contracts (including LEAPS and standard options) permitted on the underlying equity is heavily limited. These limits are set in accordance with the number of outstanding shares and the trading volume of the underlying equity.

The larger, more frequently traded stocks are assigned initial position limits of 75,000 contracts, while less active issues are assigned initial position limits of either 60,000, 31,500, 22,500, or as few as 13,500 contracts for the smallest of traded issues. As a result of stock splits, mergers, acquisitions, and other factors, these limits are periodically adjusted. Position limits are imposed by the various options exchanges to prevent any person or entity from controlling the market on a given issue. Because every option contract has both a buyer and a seller, the open contract count is the sum of the number of opening calls bought and the number of opening puts sold, so as not to double count.

Using Options to Buy Stocks

There's no way around it, buying stocks takes money. But by now you've guessed where the money for buying stocks can come from: not out of your pocket but from the premiums accumulated from the sales of the LEAP puts. As described in the preface, the purpose of my selling LEAP puts was not just to enhance the cash flow and dividend yield of my stock portfolio. Rather, it was to furnish the funds with which to continue stock acquisition.

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

 Table  LEAPS Available August 1999

Table  LEAPS Available August 1999 

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999


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