A long term option is considered any option with an exercise date more than one year in the future. This type of option strategy is most often referred to by the acronym LEAPS, meaning Long-term Equity AnticiPation Strategies. The main benefit of LEAPS is that they are longer term than most options; this type of option position can be held for as long as three years.
Levering Your Position
One of the main benefits of an option is that it allows you to lever your position. The only payment to open a position on an option is the premium. Any movement of the underlying stock price beyond the option strike price is considered in the money. When the difference between the underlying stock and the strike price is greater than the exercise price, any additional movement in the stock will be purely profit. At and beyond this point, the profit gained by the option is exactly the same as the profit that would have been generated through purchasing the underlying stock outright.
The important thing to keep in mind is that the option premium was less than the cost of purchasing the underlying stock outright. This means that, though nominal profit may be equal, the percentage profit is much greater for the option. Long-term options are an excellent levering strategy for an investor who is at least moderately bullish or at least moderately bearish in their market outlook.
Buy and Hold
The premiums on long-term options are generally higher. This is because as the option duration increases, there is a greater risk on the option writer’s side that the option will end up in the money. The higher option premium is a compensation for that increased risk. Due to the increased premium, option purchasers tend to be at least moderately bearish or bullish; they must believe that the underlying stock price will move enough to net them a profit.
The buyer of a call option is making a bet that the price of the underlying stock will go up. Purchasers of long call options will have a bullish view of the market. This strategy is similar to a buy-and-hold equity purchase strategy with a company that does not pay dividends. The buyer of the option will depend on an upward trend in the price of the underlying stock to make a profit.
Conversely, the buyer of a long-term put option is banking on the underlying stock decreasing in value. Purchasers of a long-term put option have a bearish market outlook. This strategy can be compared to a leveraged shorting of a stock.
In times when unusual gains on a position have occurred, long-term options can be used to hedge a position. In the case of an investor with an open long position who has just realized large gains, a long-term put can be purchased to hedge the gains. If the stockholder expects a future decrease in the stock price, the put will protect the gains at a minimal cost to the stockholder. The only expense is the premium on the option. If the stock falls, the money lost through holding the underlying stock will be equal to the money gained through holding the put option. The profit is preserved; the only things that add or subtract to this profit are the option premium, additional increases in the underlying stock price, and dividends paid to the stockholder.
Christian Barclay is currently an undergraduate in the Farmer School of Business at Miami University of Ohio. He has research experience in the field of chemical engineering and interned this previous summer at the Four Seasons Nile Plaza in Cairo, Egypt. He has written for Demand Studios since May 2009 and has been published on eHow.com and Golflink.com.