Course 502: Introduction to Options
Basic Option Strategy--Leaps
In this course
1 Introduction
2 Call and Put Options on Stocks
3 What Is an Option Contract?
4 Understanding Option Pricing
5 Drivers of Option Value
6 Basic Option Strategy--Leaps
7 Another Strategy--Baby Puts
8 The Bottom Line

There are literally scores of option strategies. Straddles, strangles, and butterflies are just some of the main types of strategies where an investor can use options (or sets of options) to bet on any number of stock and market movements. Most of these are beyond the scope of this lesson, so we will just focus on two strategies most often used by value investors.

First, leaps are options with relatively long time horizons, typically lasting for a year or two. (The term "leaps" is an acronym for "long-term equity anticipation securities.") Some value-oriented investors like call option leaps because they have such long time horizons and typically require less capital than buying the underlying stock.

For example, a stock may be trading for about $60, but the call options with two years to expiration and a $70 strike price may trade for $10. If an investor thinks the stock is worth $100 and will appreciate to that price before the leap expires, he or she could find the leap very attractive. Rather than spending $6,000 to purchase 100 shares of the stock, he or she could buy one leap contract for $1,000 (1 contract x $10 x 100). If the stock closes at $100 at expiration two years from now, the leap position would return $2,000 (1 contract x ($30 – $10) x 100). This would mark a $2,000 profit on a $1,000 investment (200%). However, if he or she had just purchased the stock, it would have marked a $4,000 profit on a $6,000 investment (67%).

As we see above, leaps can offer investors better returns. However, this bigger bang for the buck does not come without some additional risks. If the stock had finished at $70, the leap investor would have lost his/her $1,000 while the stock investor would have made $1,000. Also, the leap investor doesn't get to collect dividends, unlike the stock investor.

Let's also consider a case where this stock trades at $70 at the leap's expiration, but then goes up to $110 soon after expiration. The owner of the stock enjoys the appreciation to $110, but the option holder in our example is out of luck.

This latest example highlights perhaps the reason why options are a tough nut to crack for most investors. To be successful with options, you not only have to be correct about the direction of a stock's movement, you also have to be correct about the timing and magnitude of that movement. Deciding whether or not a company's stock is undervalued is difficult enough, and betting on when "Mr. Market" is going to be in one mood or the other adds great complexity.

Next: Another Strategy--Baby Puts >>


Search
Print Lesson |Feedback
Del.icio.us Del.icio.us | Digg! digg it
Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.
Copyright 2015 Morningstar, Inc. All rights reserved. Please read our Privacy Policy.
If you have questions or comments please contact Morningstar.