LEAPS: Options for the Long Term - Part 3

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...continued from Part 2

AVAILABILITY OF LEAPS
Several factors impact the availability of LEAPS. When options are listed for trading on a particular stock, most times LEAPS are not immediately available. After a period of time, and if interest warrants it, the exchanges listing the shorter-term options may decide to list LEAPS options, after consulting with the market-makers or specialists assigned to trade the stock options.

The reason for this is that LEAPS options are difficult to price because of their long life. The exchanges ensure that sufficient interest is present in the market, and that market-makers or specialists are prepared to price and trade longer-dated options once they are listed.

The result is that LEAPS are not available on every stock which has options traded on it. LEAPS are initially listed with three strike prices, at the current price and 20 to 25% above and below the price of the underlying stock. Strikes may be added as the underlying stock moves. LEAPS only have one expiration month: January in two different years.

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As LEAPS draw within one year of their expiration and it becomes necessary to list new LEAPS series, the existing LEAPS options continue to be listed and traded until their expiration. However, because of the shorter length of time until expiration, they then trade as ordinary shorter-term options and they lose their distinctive LEAPS symbols. New LEAPS options with expiration dates in the future are then added.

In order to determine if LEAPS® are available on a stock that interests you, consult our Directory of Listed Options (xls format). LEAPS® account for approximately 10% of all options listed. LEAPS® are proving themselves very attractive to an ever-increasing number of options investors and traders.

PRICING LEAPS
Options pricing models contain five factors that are used to determine a theoretical value for an option: stock price, strike price, time to expiration, interest rates (less dividends) and volatility of the underlying stock.

With shorter-term options, it is fairly straightforward to use an interest rate which approximates the "risk-free" interest rate; most people use the U.S. Treasury-bill rate (90-day). However, to price a LEAPS option, it is necessary to predict the volatility (expectation of price fluctuation) of the underlying stock and interest rates over 2 ½ years; this is difficult even for most professionals.

In short, pricing longer-term options is more difficult than pricing shorter-term options. Of the five factors mentioned above, interest rates play a more significant role in the pricing of longer-dated options, due to the length of time involved. For these reasons, professionals are not ready to instantly quote prices of options with maturity dates far into the future, since the predictability of the inputs is so much more unreliable than for shorter-term options.

Despite these difficulties, investors will find that exchange policies generally require market-makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS whenever the decision is made to use them. 
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