Ask the Institute

Ask the Institute Archive

DATE: March 22, 2002

QUESTION:
Why would I want to be long stocks when I could be long LEAPS®? What are the disadvantages to owning LEAPS as opposed to the underlying stock?

ANSWER:
Every strategy has a tradeoff, some relative advantage and some relative disadvantage.

There are two advantages to owning a LEAPS call relative to owning the underlying stock. First, the investment in a LEAPS call is less than buying the underlying stock. Second, it is likely that the profit potential in percentage terms is greater for the LEAPS call than for an investment in the underlying stock. This is generally described as "leverage."

On the other hand, there are also some disadvantages to owning a LEAPS call relative to owning the underlying stock. First, because of the time premium portion of the LEAPS call, the break-even point at expiration, is higher for the LEAPS call than for the stock. Consequently, it is possible for the stock price to rise slightly and for the stock owner to have a small profit while the owner of a LEAPS call might have a loss or only break even. Second, there is the issue of time. A LEAPS call has an expiration date, and it is possible for the option to expire worthless, causing a 100% loss of the premium paid, while the stock continues to live for a price rise after the expiration date of the LEAPS call. Third, the "leverage" factor which worked to the advantage of the LEAPS call in the case of a stock price rise can be a disadvantage in the event of a stock price decline. Remember that unlike stocks, options do not receive dividends or carry voting rights.


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