LEAPS Put Options Q&A;
Q: I'm a novice. Please explain again what LEAPS puts are.
A: LEAPS puts are just long-term put options — options that give you the opportunity to profit from a decline. If the decline does not take place before the LEAPS expire, you could lose your entire investment, but never a penny more. If the decline does take place, you have the potential to make windfall profits.
Q: I have tried to match the LEAPS to the market but don't see the correspondence. For example, instead of being at, say, 8,000, the Dow Jones LEAPS are set to 80. How does that work?
A: OK. Say your put option is the Dow Jones December 2003 LEAPS put option with a strike price of 80, the Dow Jones Industrial Average itself is not the index. Instead, the LEAPS are tracked against a special index, called DJX, which is set to 1/100th of the Dow Jones. So if the Dow is at 9000, the DJX will be 90. If the Dow falls to 5000, the DJX will fall to 50. The same principal is used for LEAPS of other indexes, such as the S&P;, as well.
Q: So how do I make money on LEAPS puts?
A: The simple answer is that you buy the LEAPS low and sell them high — just like you would a stock. Let's say, for example, that the LEAPS puts are selling for about $7.40 per share ($740 for the minimum contract representing 100 shares). If the Dow falls to 5000, the value of the LEAPS put options should surge to at least $30 per share.
Q: Please explain how that works.
A: This particular LEAPS put gives you the theoretical right to sell 100 units of the DJX at 80, anytime between now and December 2003.
Q: OK. Suppose the Dow falls to 7000. The index would be at 70, right? Do I have to tell my broker to sell the index for 80 and then buy for 70?
A: No. All you have to do is sell the LEAPS put on the market. So the only thing you have to worry about with your LEAPS is buying low and selling high — just like any other investment. Here are some scenarios:
- Say the Dow Jones falls to 7000 before December 2003, just like you said. The DJX will be 70. So your LEAPS put should be worth at least $10 per share (80 minus 70).
- Or, say the Dow Jones falls to 6000. The DJX index will be 60, and your LEAPS put should be worth at least $20 per share (80 minus 60).
- Now say the Dow falls to 5000. Your LEAPS put should be worth at least $30 per share (80 minus 50). So you'd take away $3,000, per contract on an initial investment of $740.
Q: Could it be worth more than that?
A: If you still have some time left in the option when you sell it, it should definitely be worth more than that. If there's a lot of time left, it will be worth a lot more. If there's only a short time left, it will be worth only slightly more.
Q: What could go wrong?
A: The Dow could go up or sideways. Or it could fall too slowly, never making it down to 8000. If that happens, and you hold the LEAPS put until the end of 2003, it will expire worthless. You will lose the entire $740 that you paid for the option plus any brokerage fees, but not a dime more.
Q: But my broker won't buy them for me. He says I can't trade options.
A: Call your broker and say: "I am interested in purchasing LEAPS options to help divesify my overall portfolio. I am aware of the risks involved and I will only invest a modest percentage of my assets." But before you do this, make sure that you are aware of all the risks involved in trading options. You can learn more about the advantages and disadvantages of options in the Options Pros and Cons section of this guide.
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