Options are usually seen as tools for the "fast money" crowd. If an option trader can correctly forecast a stock's price within a specific time frame and buy the appropriate option, huge profits can be made in a few months. However, if the prediction is wrong, then the same option could easily expire worthless, wiping out the original investment. However, options can also be useful for 澳洲幸运5官方开奖结果体彩网:buy-and-hold investors. Since 1990, investors have been able to buy options with expiration dates ranging from nine months to three years into the future. These options are known as LEAP (Long-Term Equity Anticipation Securities) options.

Understanding Rolled LEAPs

Investors can purchase a LEAP 澳洲幸运5官方开奖结果体彩网:call option contracts instead of shares of stock in order to get similar long-term investment benefits with less capital outlay. Substituting a financial 澳洲幸运5官方开奖结果体彩网:derivative for a stock is known as a 澳洲幸运5官方开奖结果体彩网:Stock Replacement strategy and i꧒s used to improve overall capital efficiency.

The biggest problem with options for the buy-and-hold investor is the short-term nature of the security. And even LEAP options with expirations over a year may be too short for the most ardent buy-and-hold investor. However, a LEAP option can be replaced by another LEAP with a later expiry.

For example, a two-year LEAP call could be held for a single year and then sold and replaced by another two-year option. This could be done for many years, regardless of whether the price of the 澳洲幸运5官方开奖结果体彩网:underlying security goes up or down. Maꦆking options a viable choice for b♚uy-and-hold investors.

Selling older LEAP calls and purchasing new ones in this manner is called the Option 澳洲幸运5官方开奖结果体彩网:Roll Forward, or sometimes just the Roll. An investor makes𓃲 regular small cash outlays in order to maintain a large leveraged investment position for long periods.

Rolling an option forward is inexpensive because the investor is selling a similar option with similar characteristics at the same time. However, predicting the exact cost is impossible because option pricing depends upon factors such as 澳洲幸运5官方开奖结果体彩网:volatility, 澳洲幸运5官方开奖结果体彩网:interest rates, and 澳洲幸运5官方开奖结果体彩网:dividend yield that can never be precisely forecasted. Using the spread between a two-year and one-year option of the 澳洲幸运5官方开奖结果体彩网:underlying security at the same 澳洲幸运5官方开奖结果体彩网:strike price is a reasonable proxy.

Using LEAP calls, like any stock-replacement strategy, is most cost-effective for securities with low volatility, such as index or sector ETFs or 澳洲幸运5官方开奖结果体彩网:large-cap financials. There's always a tradeoff between how much cash is initially put down and the 澳洲幸运5官方开奖结果体彩网:cost of capital for the option. An at-the-money option on a low-volatility stock or ETF is general💦ly very inexpensive. While an at-the-money option on a high-volatility stock will be significantly more expensive.

Leverage Ratio and Volatility

澳洲幸运5官方开奖结果体彩网:At the money, LEAP call options initially have higher leverage and volatility. Minor changes in the 澳洲幸运5官方开奖结果体彩网:market price of the underlying security can result in high 澳洲幸运5官方开奖结果体彩网:percentage changes in the price 🤡of the option. The value may fluctuate by 5% on a typical day. The investor should be prepared for this volatility.

Over perio💮ds of years, as the underlying security appreciates and the call option builds equity, the option loses most of its leverage and becomes much less volatile. Given multi-year holding periods, the resul😼ts of the investment are relatively predictable using statistics and averages.

Note that a $1 increase in the underlying security will not immediately result in a full $1 increase in the LEAP 澳洲幸运5官方开奖结果体彩网:call price. Because options have delta, they receive some appreciati𝔉on immediately and then accumulate the remainder as they get closer to expiry. This also makes ಌthem more suited for investors with longer holding periods.

Example

In this example, we've calculated the implied interest rate and 澳洲幸运5官方开奖结果体彩网:expected return on a deep-in-the-money option on SPY, the S&P 500 澳洲幸运5官方开奖结果体彩网:Index Fund tracker ETF. We've assumed an annual appreciation of ꦆ8%, before dividends and will hold the option for five years.

澳洲幸运5官方开奖结果体彩网:Discounted cash flow꧙ calculations can be used to determine both the cost of capital and the expected appreciation.

The annual roll-forward cost is unknown, but we'll use, as a proxy, the cost difference between a December 2007 option and a December 2008 option at the same strike price. It could go up or down next year, but over time, it's expected to decline. The investor will pay the roll-forward cost three times in order to extend the two-year option to a five-year 澳洲幸运5官方开奖结果体彩网:holding period.

Note that in the above example, we excluded dividends. Option holders don't receive dividends, but they do benefit from lower 澳洲幸运5官方开奖结果体彩网:option prices in order to account for the expected fℱuture dividend payments. When calculating expected returns for any LEAP, be consistent and either include or exclude dividends from both the cost of capital a𝕴nd the expected appreciation.

The Bottom Line

Most buy-and-hold investors and index investors are not aware that LEAP calls can be used as a source of investment debt. Using LEAP call options is more complex than purchasing stock on margin, but the rewards can be a lower cost of capital, higher leverage, and no risk of 澳洲幸运5官方开奖结果体彩网:margin calls.

LEAP call options may be purchased and then rolled over for many years, which allows the underlying security to continue to compound as the investor pay💟s the roll-forward costs. If the option is de🐬ep in the money and the underlying security has low volatility, then the cost of capital will be low.

LEAP calls can give investors the ability to construct long-term portfolios of stocks or index ETFs and thereby control larger investments with less capital. In the above example, an investor could control a $143,81꧂0 index portfolio for a $31,600 🌱initial payment.

Of course, it's always important to plan purchases, sales, and future roll-forward costs carefully, as exiting a large leveraged investment during a downturn will most likely lead to significant losses. Despite the fact that many option buyers are short-term hedgers or 澳洲幸运5官方开奖结果体彩网:speculators, an arg🤪ument could ꦡbe made that leveraged investments are only appropriate for investors with very long horizons.