Chapter 25: LEAPS FIGURE 25-1. LEAPS call pricing curve. 45 40 35 Q) 30 .g o. 25 'lii U 20 15 10 5 , .... ,, Various Expiration Dates Strike= 80 2 Years (LEAP) , ' ' ,,,,' ,, ,, ,, ,, ,, "' ,, ,, ,, ,, ,,' ,, ,. ,, ,, 0 L----~==--..l.---..J£----1.---L----.I....-- 60 70 80 90 100 110 Stock Price 371 Before that discussion, however, it may be beneficial to examine the effects that interest rates and dividends can have on LEAPS. These effects are much, much greater than those on conventional equity options. Recall that it was stated that inter­ est rates and dividends are minor determinants in the price of an option, unless the dividends were large. That statement pertains mostly to short-term options. For longer-term options such as LEAPS, the cumulative effect of an interest rate or div­ idend over such a long period of time can have a magnified effect in terms of the absolute price of the option. Figure 25-2 presents the option pricing curve again, but the only option depict­ ed is a 2-year LEAPS. The striking price is 100, and the straight line at the right depicts the intrinsic value of the LEAPS. The three curves represent option prices for risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration, volatility, and dividends) are fixed. The difference between option prices caused merely by a shift in rates of 3% is very large. The difference in LEAPS prices increases as the LEAPS becomes in-the­ money. Note that in this figure, the distance between the curves gets wider as one scans them from left to right. The price difference for out-of-the-money LEAPS is large enough- nearly a point even for options fairly far out-of-the-money (that is, the points on the left-hand side of the graph). A shift of 3% in rates causes a larger price difference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen­ tial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but when LEAPS strategies are examined later, the reasons for this will become clear.