Looking at LEAPS:
They could be long-term alternatives to stocks

By ERIN E. ARVEDLUND, Barron's, April 2, 2001

Warren Buffett thinks many U.S. stocks are still overvalued and need to drop further to be a good investment. In London for the delivery of some new aircraft, Buffett quipped, "We're buying more planes than we are stocks."

If the Berkshire Hathaway chairman has little interest in stocks right now, why should you have more? Instead, consider buying or selling LEAPS, or long-term equity-anticipation securities. These are listed options with maturities as long as two to three years.

By buying LEAPS options, you have time on your side. Plus, you lay out a fraction of the cost of the stock now to buy the shares at a fixed price later. Or you can sell LEAPS call options to take advantage of today's high option prices and depressed stock quotes. But it's probably best to do so only on a "covered" basis, meaning that you sell options only if you own the underlying stock at the same time.

Also, if you buy the underlying stock on margin and then sell LEAPS, be prepared for a potential nightmare. Some brokerage firms are now restricting the use of option premiums from LEAPS sales; investors have been using them to reduce margin deposits.

During the recent stock-market debacle, many investors who sold LEAPS used the premiums to pay for margin. But they watched in horror as stocks gapped down more than the option premiums and suddenly found themselves with "negative equity" in their accounts. They had to liquidate their option positions to meet margin calls.

Which stocks should you should write LEAPS against? Conservative option traders have a golden rule: Find a stock you wouldn't mind owning and on which you have an opinion on the fundamentals.

For more information on LEAPS and margin requirements, visit the Chicago Board Options Exchange Web site (www.cboe.com/products/) or the Options Industry Council (www.888options.com). For more sophisticated option pricing, visit DerivativesModels.com (Its address is www.derivativesmodels.com).

Since Wall Street could soon start promoting single-stock futures as an alternative to options, they are worthy of comment.

[chart]Similar to single-stock options, single-stock futures are contracts under which investors commit themselves to buying or selling a stock at a set price on a certain date. The difference? With options, the investor has the right to buy or sell the security. With futures, the investor has the obligation to buy or sell the stock.

Single-stock futures could begin trading in the U.S. first on the Nasdaq Stock Market, which last week formed a partnership with LIFFE, the London International Financial Futures and Options Exchange. Until a change in the law late last year, U.S. investors had been barred from investing in single-stock futures because of fears of market manipulation. Institutions may now trade single-stock futures starting in August, and retail customers may in December.

But do investors actually want single-stock futures? Other than some hedge funds, few are clamoring for them. As a stock substitute, "single-stock futures would have been useful when IPOs were coming out with very little float," points out Tony McCormack, Charles Schwab's vice president charge of option operations in Chicago. Otherwise, single-stock futures could help those in the stock-loan business, since shorting with futures is theoretically cheaper.

The Nasdaq-LIFFE partnership points up some awkward truths. First, the vaunted Nasdaq-Amex merger (remember that?) is quietly dissolving, as the Nasdaq increasingly cuts deals sidestepping the American Stock Exchange.

Second, whatever the merits of single-stock futures, Nasdaq is now set up to trade and settle these instruments, not the nation's largest options exchanges. Says Chinh Chu, senior managing director at Blackstone Group, an investor in LIFFE: "We've been very active in seeking out the best partner. We deemed Nasdaq the best because of their expertise, their brand name and aggressiveness."

Questions:

  1. If you held a stock and wanted to protect yourself from a loss, you could use a single-stock future or an option.  Which would you use, in what circumstances?
  2. If you subscribed to the semistrong-form efficient market hypothesis (stock prices reflect all publicly available relevant information), under what circumstances would it make sense for you to buy or sell single-stock futures?
  3. "If the Berkshire Hathaway chairman has little interest in stocks right now, why should you have more? Instead, consider buying or selling LEAPS, or long-term equity-anticipation securities."  Explain the underlying assumptions.  (Think of the circumstances under which this statement would make sense.)