Long-Term Options versus Margin

Long-term options (or Long Term-Equity AnticiPations or LEAPs as they are known within the industry) are interesting for more than the fact that they provide a demonstrative example of the option industry’s love affair with acronyms.

LEAPs are long-term options with expirations that stretch beyond the nine month time line associated with traditional option contracts. Veteran traders will recognize LEAPs as warrants which were popular tools to leverage stock positions long before the introduction of exchange traded options.

LEAPs eliminate timing issues that short circuit so many aggressive option strategies.
Simply stated there is significantly less time value decay on a longer term option than would be the case with a shorter term contract. For example a three-month XYZ at-the-money call option trading at $3.00 would be worth $2.375 (assuming the underlying stock and volatility assumptions remain unchanged) one month later… a decline of 21%.

Stretch out the term to expiration and an XYZ at-the-money call option with 24 months to expiry would decline only 2% (i.e. from $9.625 to $9.375) given the scenario from the previous example.

Because LEAPs reduce the impact of time they can be a viable substitute for investors who typically buy stocks on margin. Consider a scenario when an investor is looking to buy 1000 shares of XYZ at $50 per share on margin. Because XYZ is an option eligible security investors would only have to put up $15,000 (20% of the stock’s purchase price) at the time of purchase.

As an alternative one could buy a two-year XYZ call LEAP with a $35 strike price at say $18.75 per share. Since we are comparing the merits of buying on margin to the purchase of call LEAPs, we need to define the costs associated with each position.

While margin rules only require 30% of the cost of the stock be placed in the account that is not how most investors would approach this trade. In the real world, you would probably put up 50% of the value of the stock so as to avoid a margin call in a declining market.

In that case the investor would put up $25,000 to buy the shares on margin versus $18,750 ($18.75 x 10 contracts x 100 shares) to buy ten XYZ two-year XYZ call LEAPs with a strike price of $35 per share. To maintain an apple to apple comparison we’ll assume the LEAP buyer deposits $25,000 into the account, and of that, spends $18,750 to buy the ten contracts.

To keep things simple we will assume no interest is earned on the cash balance nor paid on the margin debit. Given the caveats let’s examine the profit and/or loss from both positions over the next three months assuming 1) XYZ rises to $60 per share or 2) XYZ falls to $40 per share.

Under the first scenario, the XYZ LEAPs should be worth $27.50 ($27,500 total value). Add to that the $6,250 that remained from the initial deposit leaves us with a total account value of $33,750, a 35% return on the initial investment.

The trader buying on margin would hold 1,000 shares of XYZ valued at $60,000. The net equity after accounting for the $25,000 loan is $35,000 which represents a return of 40%. Just slightly better than the LEAPs!

Should XYZ decline to $40 per share, the LEAPs will be worth $10 ($10,000), plus the $6,250 in cash for a net account value of $16,250… representing a 35% loss on the initial $25,000 investment.

In the margin account the portfolio would be worth $40,000 with a $25,000 debt. The net value of the portfolio would then be $15,000 for a loss of 40% or slightly more than the loss associated with the LEAPs.

So the LEAPs strategy offers less upside but with protection to the downside. Using those metrics the LEAP strategy is less risky than the margin position over short periods. Further LEAPs allow the investor to approach this strategy with a pre-determined risk level and because LEAPs cannot be margined, there is no risk of a margin call that could lead to an early sell-out.

Of course veteran option traders would ask why one would not simply use three-month options rather than two-year LEAPs? The problem comes down to timing entry and exit points. With short-term options you pay a hefty price if you are right about the stock’s direction but wrong about the timing.

LEAPS is a registered trademark of the CBOE and Long-term Equity AnticiPation Securities is a trademark of the CBOE.