Equity LEAPS Calls vs.

Stocks: An Empirical Study for

Long-Term Speculation
S. Leila Beheshti Shirazi
University of Malaya
Izlin Ismail
University of Malaya
ABSTRACT
Long-Term Equity Anticipation Security or LEAPS is a call option introduced as a more conservative
security that can replicate a common stock position. This studys objective is to examine the effect of
applying the strategy of Buying In-The-Money LEAPS Calls vs. Purchasing Stocks proposed by CBOE
on the performance of traders in terms of risk and return trade-off and the risk-adjusted performance in
practice, using a sample of 54 common stocks listed on NYSE and NASDAQ and 54 LEAPS calls on the
same underlying stocks listed on CBOE during 2008-2010. The results indicate that LEAPS calls are not
a preferred financial instrument to replace common stocks for risk-averse traders. When the stock market
experiences a progressive downturn trend, the portfolios of LEAPS calls provide much higher negative
returns, significant loss and poor performance as well as higher levels of volatility relative to the
portfolios of common stocks. The results of this study also suggest that risk-seeking traders, who can
tolerate the higher level of risk in compensation for higher returns, choose the portfolio of LEAPS calls
with high Book-To-Market (BTM) ratio assets. This portfolio is less volatile relative to the portfolio of
LEAPS with low BTM ratio and provides higher rates of return in comparison to the portfolios of
common stocks in favorable market conditions.
Keywords: Equity LEAPS call, common stock, long-term speculation, return, volatility, mean, variance,
risk-adjusted performance, Sharpe ratio, Treynor ratio, Jenson Alpha.
JEL Classification: G11, F39

1. Introduction
Derivative securities have become an integral part of the financial markets in the past four decades due to
their important functional uses including risk management or hedging, speculation, and arbitrage
opportunities in the marketplace (Lapan et al., 1991; Bartram, 2003; Apostolou et al., 2005; Kumar,
2007). Based on different motives, some traders purchase derivatives to manage their financial risks while
others use these securities to speculate on price movements of the underlying assets (Kumar, 2007). For
the most part, derivatives are used as a risk management tool rather than for speculation by portfolio
managers and individual investors1. This study will, however, focus on the speculative use of derivatives.
Speculation is defined as buying, holding and selling of any valuable financial asset to profit from the
fluctuations in its price (Hiriyappa, 2008). Any speculative decision to buy or sell a financial asset
involves market timing to obtain the best price (Emery, 1896). Due to the need to precisely time the
1

It is usually believed that the term speculation refers to a short-term financial action and the term investment to a long-term one (Brandes, 2003; Hiriyappa,
2008). However, Nagarajan & Jayabal (2011) avoid distinguishing them based on their holding period and explain that the distinctions between speculation
and investment are the degree of risk involved and the motives of traders. The element of risk involved in speculation is significantly higher than that of
investment. A speculator tends to take a higher level of risk when anticipating a higher level of return in the future. Also, an investors motive is to increase
his/her income from the securities whereas a speculators motive is the capital appreciation. Thus, even those who buy and hold securities for decades, may be
classified as speculators, except only the rare few who are primarily motivated by income or safety of principal rather than selling at profit. Thus, in this paper
the term investors and long-term speculators are used interchangeably when the motives of both investors and long-term speculators are earning profit from
price fluctuation in the future.

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market, speculation on derivative securities which usually have a short life span entails running the risk of
loss in the expectation of high reward (Farhi & Borghi, 2009). Bauer, Cosemans & Eichholtz (2008)
found evidence that most individual investors who trade short-term options to speculate on stock price
movements have incurred substantial losses on their investments and they concluded the poor market
timing was the main determinant of their under-performance.
As such, the development of longer maturity derivatives has reduced the risk of speculation on
derivatives and removed the need for precise timing of the market. One of these longer maturity
derivatives is LEAPS or Long-Term Equity Anticipation Security. LEAPS is a long-term option with the
expiration date of up to three years (CBOE, 2001; Lasher, 2007). Compared to the short-term options,
LEAPS provide a longer time frame for option traders to benefit from favorable price movement in the
market. LEAPS traders do not need to time the market in a short run and be too concerned about the
accuracy of their predictions (CBOE, 2001; Apostolou et al., 2005). The longer-term maturity of LEAPS
contracts has removed the most inhibiting factor of options, i.e. market timing (Thomsett, 2009).
Generally, option is a best way to gain leverage in the stock market and at the same time speculate on
favorable price movement in the underlying assets. Due to the effect of leverage, small changes in the
value of the underlying assets produce big changes in the value of options (Wilmott, Howison &
Dewynne, 1997). In other words, the leverage inherent in options can magnify the returns on investment
while investors only pay a fraction of total capital required for the securities (Apostolou et al., 2005;
Lasher, 2007). However, leverage can magnify the risk of investment as well and traders have to take a
greater level of risk for speculating on options relative to stocks (Lasher, 2007).
Like options, LEAPS offer investors a way to take long-term levered positions in the derivatives
market (OIC, 2008). Due to the effect of leverage, gains from LEAPS calls can be sometimes 4-5 times
greater than those of the underlying stocks (Lasher, 2007). This factor has encouraged a new generation
of market participants, who are more risk takers, to become interested in trading LEAPS calls instead of
common stocks to earn greater returns from the favorable price movement of the underlying assets. On
the other hand, it is believed that buying LEAPS calls can be a more conservative approach relative to
purchasing common stocks outright in a volatile stock market condition because investors will not be
putting their whole capital at risk and just limit the risk to the premium amount paid (Thomsett, 2009).
Due to these factors, many financial advisors and option specialists currently (McMillan, 2002; Taylor,
2008; Rahemtulla, 2009, Zigler, 2010) suggest investors and long-term speculators to construct their
portfolio with LEAPS calls rather than stocks and/or replace the existing stocks in their portfolios with
LEAPS calls. Moreover, CBOE has introduced a new investment strategy of Buying In-The-Money
LEAPS Calls vs. Purchasing Stocks in its official website to inspire investors to replace LEAPS calls
with the underlying stocks in their portfolios of investment. Therefore, many option traders are attracted
to buy LEAPS calls to speculate in the stock markets over a longer period of time (Allaire & Kearney,
2002). However, we were unable to find a study in literature to examine the performance of the long-term
speculators by applying this strategy in practice in terms of risk and return trade-off and risk-adjusted
performance. As such, the risk and return tradeoff and the performance of a portfolio of LEAPS calls in
practice are still under question. Investors are unaware of the actual level of returns and risks that they
will experience in adopting this strategy. There is, thus, a need for investors to ensure the preference of
investing on a portfolio of equity LEAPS calls over a portfolio of common stocks.
This study attempts to measure the risks, the returns and the risk-adjusted performances of the
portfolios of equity LEAPS calls and those of the portfolios of the underlying stocks to compare them
together and explore any preference of each. The risk-adjusted performance of these portfolios would be
measured using the Sharpe, Treynor and Jenson measures. This study also attempts to increase the
understanding of investors or long-term speculators regarding their success or failure in the market by
buying LEAPS calls instead of common stocks.
The findings of this study can help those investors or long-term speculators who do not have sufficient
capital to purchase various expensive stocks in the stock market and instead are willing to buy LEAPS
calls in the derivative market to benefit from favorable price movement. This study also would make a

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contribution to the literature in the area of speculating in options, specifically LEAPS calls. It is also
anticipated that this study will motivate others to conduct further research on speculating in LEAPS calls
within different periods of time and investigate the performance of investors or long-term speculators
adopted this investment strategy in the financial markets.

2. Literature Review
Investors preference to trade options rather than stocks is to benefit from lower transaction costs, to
avoid tax exposure and to bypass stock market restrictive rules (Kolb & Overdahl, 2007). As the value of
options depend on the price of the underlying stock, buying options is viewed as a substitute for direct
purchase or sale of stocks (Bodi, Kane & Marcus, 2009). In this context, Kolb & Overdahl (2007) explain
that many investors trade options to speculate on the price movement of the underlying stock.
Educated traders with speculative motives have moved toward trading LEAPS rather than short-term
options (Roth, 1994). LEAPS were introduced by Chicago Board Option Exchange (CBOE) in 1990 as a
new investment tool (Roth, 1994; Allaire & Kearney, 2002; CBOE, 2001). Longer expiration period of
LEAPS overcomes the ongoing struggle of option traders with time. Also, the length of time included in
this security allows the underlying security to continue to compound over the time (Allaire & Kearney,
2002; OIC, 2008). Moreover, LEAPS provides less leverage for investors because the buyers of LEAPS
have less time premium erosion relative to the buyers of short-term options (CBOE, 2001; OIC, 2008)
These factors make LEAPS less volatile and risky (CBOE, 2001; Weiyu Guo, 2003) and helps LEAPS
traders lower their risk on investing in options (Holland & Wingender, 1997).
Currently there are a limited numbers of studies on LEAPS. Among the few existing studies, there are
some empirical explorations concerning the pricing of SPX LEAPS (Bakshi et al., 2000) and equity
LEAPS (Weiyu Guo, 2003) through Black-Scholes model, the volatility dynamics of LEAPS on S&P 500
stock market index (Bollerslev & Mikkelsen, 1999), trading volume of LEAPS (Weiyu Guo, 2003), and
the relationship between the introduction of LEAPS and changes in the value of underlying stocks
(Lundstrum & Walker, 2005).
Generally, LEAPS is classified into two main categories: Equity LEAPS and Index LEAPS. Equity
LEAPS are American options that can be exercised at any time before the expiration date, while Index
LEAPS are European options which can only be exercised at the maturity (Roth, 1994; Allaire &
Kearney, 2002). The exercise of equity LEAPS results in the delivery of the underlying stock but index
LEAPS are settled with cash (OIC, 2008).
McMillan (2002) claims that equity LEAPS calls can be used as a substitute for common stocks for
investors intending to reserve their capital. Compared to stocks, equity LEAPS calls can provide investors
a greater percentage return due to the leverage effect, limited risk of investment to the premium amount
paid, less capital requirement at a fraction of buying stocks outright, and the same performance as stocks
(CBOE, 2001).
2.1. Return on Equity LEAPS Calls

Due to the inherent leverage, options provide magnified returns on investment (Apostolou et al., 2005;
Kolb & Overdahl, 2007; Gurusaour, 2009). Evidence on S&P index shows that the returns on call options
are significantly larger than those on the underlying stocks; by an average of two per cent per week
(Coval & Shumway, 2001). This is due to the fact that options have a convex payoff (Begley & Feltham,
1999; Guy, 1999; Bryan, Hwang & Lilien, 2000) while the payoff on stocks is linear.
With regard to moneyness, deep in-the-money (ITM) LEAPS calls have higher delta and more
potential to earn significantly higher returns (CBOE, 2008; OIC, 2008) than at-the-money (ATM) LEAPS
calls with relatively low delta and less potential to earn high returns (OIC, 2008). ITM equity LEAPS
calls can even provide much higher returns on the original investment for investors relative to the returns
on ATM LEAPS calls and common stocks. In this context, Lowel (2009) explains that deep ITM (DITM)
call strategy is the best way to artificially own a stock with half the money outlay and less risk.

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2.2. Risk on Equity LEAPS Calls

Higher return is not the only factor that investors consider in an investment decision. The other significant
parameter is the risk on investment that investors aim to decrease it as much as possible. Unlike other
investments with unlimited risks, LEAPS offers a known risk to traders which is limited to the premium
amount paid for them (OIC, 2008). As noted before, an equity LEAPS call holder benefits from stock
price appreciation but does not incur loss more than the premium paid if the share price fall (Allaire &
Kearney, 2002; McMillan, 2002). This means that trading LEAPS is less risky than the underlying stock
in terms of the total value of investment. In this respect, McMillan (2002) claims that if investors
substitute LEAPS calls instead of their stocks, they will suffer less risk due to the cheaper cost of LEAPS
than that of stocks.
However, it is significant to note that LEAPS calls have high implied volatility which is known as a
significant risk factor (Allaire & Kearney, 2002). The high implied volatility of LEAPS calls is a great
concern of traders intending to invest on LEAPS calls and may prevent them from investing in LEAPS
calls.
2.3. Risk and Returns of a Portfolio of Equity LEAPS Calls

LEAPS calls can be used to construct a long-term portfolio of stocks but with less capital outlay
(McMillan, 2002). Taylor (2008) suggests investors create a portfolio of stocks with LEAPS because
LEAPS can provide them greater diversification, manageable risk, and higher return.
The higher implied volatility of LEAPS calls (Allaire & Kearney, 2002) and volatility factors create a
significant variation in portfolio returns (Coval and Shumway, 2001). In this regard, Banerjee et al.
(2007) found evidence that VIX2 variables (volatility) significantly affect excess returns for most
portfolios. This relationship is stronger for portfolios that have higher beta values (like a portfolio of
options). It implies that the high implied volatility of LEAPS calls will result in larger excess returns for a
portfolio of LEAPS calls.
An option portfolio has higher beta and risk profile compared to a stock portfolio (Crouhy, Galai &
Mark, 2002; MacMilan, 2002). The high beta of an option portfolio makes its returns significantly
volatile. Consistently, Sears and Trennepohl (1982) found evidence that systematic risk or market
variance for an option portfolio is significantly greater than that of stock portfolio. However, they found
that the systematic risk may be reduced with the greater diversification and elimination of unsystematic
risk in a portfolio.

3. Data and Methodology

3.1 Data
The sample of underlying stocks is selected among the common stocks listed on the New York Stock
Exchange (NYSE) and NASDAQ stock market. The sample equity LEAPS calls, on the same underlying
stocks, have been chosen from the listed LEAPS calls on the Chicago Board Options Exchange (CBOE).
The S&P 500 EWI is chosen as a benchmark against our sample of equally weighted stock portfolios. The
period chosen for this study is a three year period from January 2008 to December 2011. As equity
LEAPS calls are good investment strategy when the market is bullish and considering the fact that the
economy of USA was expected to flourish in the mid 2008 according to the Wall Street Journal in April
2008, thus, this time period has been selected to test this strategy.
The samples are not randomly selected and are based on several criteria. First, we have picked the
sample securities from different industries to meet the diversification principle of Modern Portfolio
Theory (MPT) model to remove the unsystematic risk of the portfolios. Second, we have chosen the
sample based on their book-to-market (BTM) ratios. Several studies have indicated a strong relationship
between returns on assets and their BTM ratios (Rosnberg, Reid and Lanstein, 1985; Davis, 1994; Chan,
2

VIX or volatility index is introduced by CBOE in 1993. This index is calculated from the S&P 100 (OEX) stock index
options and originally computed on a minute-by-minute basis from the implied volatility of eight OEX option series.
4

Hamao, and Lakonishok, 1991; Capaul, Rowley and Sharpe, 1993), and as such, this issue has also been
taken into consideration in this study. Fama and French (1995) observed that two classes of stocks tend to
do better than the market as a whole: small caps stocks and stocks with a high BTM ratio. Following that
study, Barber, Lehavy, and Trueman (2006) designed two portfolios of high BTM and low BTM and
measured their returns. Thus, accordingly to conduct our study, we have constructed two portfolios of
stocks and two portfolios of equity LEAPS calls, one with high BTM ratio and another with low BTM
ratio, respectively, in order to ensure the robustness and sensitivity of the results in terms of returns.
Third, among the equity LEAPS calls written on the underlying stocks, only ITM equity LEAPS calls are
selected for the strategy proposed by CBOE and also consistent with the literature emphasizing ITM
options as a good substitute for common stock due to their high delta.
The relationship between portfolio performance and the number of stocks held in the portfolio has
always been an area of interest to many financial economists. Statman (1987) shows that a portfolio of
30-40 stocks can effectively achieve efficient diversification and Chung (2000) exhibits that a welldiversified portfolio contain at least 27 securities. Consistently, Wang and Yang (2007) based on the
ordinary least square method (OLS) and GARCH Model found that the optimal portfolio size in terms of
the number of stock holdings is between 21 and 28 with portfolio returns maximized and volatility
minimized. Therefore, we have decided on a sample size of 27 securities in each of the four equally
weighted portfolios.
A LEAPS position can be held even longer than three year which is the maximum expiration period of
LEAPS. LEAPS calls can be repeatedly rolled forward through a process of selling the old option and
then purchasing a new one with the same strike price but a later expiry date (Allaire & Kearney, 2002).
Through this process, long-term speculators can roll LEAPS calls over and over for many years. The
objective of rolling LEAPS over is to allow the underlying assets to appreciate over time and create profit
for LEAPS holders. To show the possibility of holding the LEAPS calls for a longer period of time and
the opportunity of appreciation in the underlying securities in this study, LEAPS calls with 2 year
expiration date traded in January 2008 are rolled over in Aug 2009 at the same strike price but later expiry
date (January 2011). The LEAPS portfolios have been rebalanced again in August 2009 to become equalweighted.
3.2 Methodology
In this study, the strategy of Buying In-The-Money LEAPS Calls vs. Purchasing Stocks proposed by
CBOE is modeled in the context of portfolios of assets. As such Markowitzs (1952) MPT is employed
for this purpose. Moreover, the strategy to buy and hold is used to measure the returns, risks and riskadjusted performance of these portfolios. The reason behind choosing this strategy is that, a buy and hold
strategy is a very popular investment strategy in the financial markets as investors believe good assets
usually grow over a long period of time, even if they seem to decline at some points. Also, buy and hold
is the preferred system of investment for small investors who are looking for a way to minimize
transaction costs.
In a fashion similar to the studies of stock returns by Fisher and Lorie (1968), stock and bond returns
by Ibbotson and Sinquefield (1976) and return and risk of alternative call option portfolio by Merton,
Scholes and Gladstein (1978), this study attempt to measure average rates of return and risks (or standard
deviation of returns) of these portfolios over the period of this study to investigate any preference of each.
Like prior studies and for the sake of simplicity, the costs associated with commission, tax, and
transactions are not taken into consideration. To measure the monthly returns of a common stock, we
follow the equation of Ibbotson and Sinquefield (1976) as,
R i,t = [(P i,t + D i,t) / P i,t-1] -1,
(1)
where Ri,t is the common stock total return during time t; Pi,t is the stock is closing price at the end of
time t; and Di,t is the stock is dividends received during time t and reinvested at the end of time t.

The returns of LEAPS calls are calculated similar to those of short-term call options. According to a
study on stock option returns by Xiaoyan Ni (2007), the returns of an individual LEAPS call from one
expiration date to next is measured as,
R i,t = [Max(S t - K, 0) / P] -1,
(2)
where Ri,t is the average return on LEAPS calls of stock i at the end of time t; S t is the closing price of
stock i at the end of time t; K is the strike price of the LEAPS at its expiration date; and P is the premium
amount paid to buy an equity LEAPS Call.
However, in the context of portfolio, we have to measure the rates of return of the portfolios, rather
than the individual assets. Based on MPT, the rate of return on a portfolio is the weighted sum of the rates
of return of the individual securities within the portfolio as,
R P,t = 27i=1 wi,t . Ri,t
(3)
where R P,t is the rate of return of a portfolio during time t; w i,t is the weight of asset i in the portfolio; R
i,t is the rate of return of asset i at the end of time t.
Furthermore, the risk of a portfolio is measured by the standard deviation of its returns (Rp). MPT
uses standard deviation to measure risk or volatility of a portfolio (Bodi, Kane & Marcus, 2009). This
model defines a portfolios risk as a function of the weighted sum of variance and the correlation of
component assets (Markowitz, 1952) as,
p,t =27i=1 w2i 2i+ 27i=1 27j=1 wiwjij ij
(4)
where P,t is the risk or volatility of a portfolio during time t; wi,t is the weight of asset i in the portfolio;
w j,t is the weight of asset j in the portfolio; 2 i is the variance of asset i in the portfolio; 2 j is the variance
of asset j in the portfolio; and ij is the correlation coefficient between the returns on assets i and j.
To obtain a reliable conclusion about the performance of these portfolios, only looking at their riskreturn tradeoff is not enough. It is necessary to utilize other tools that go beyond the mean-variance
framework. So, three types of reward-to-risk ratios including the Sharpe, Treynor, and Jenson Alpha are
applied to examine the risk-adjusted performance of these portfolios. These ratios are often used together
to rank the performance of portfolios or mutual fund managers.
The Sharpe Ratio or reward-to-variability ratio measures the excess return per unit of total risk in an
individual investment asset or a portfolio of assets. It is defined as,
S= RP - Rf
(5)
P
where RP is the return of a portfolio of assets, Rf is the risk free rate of return, and P is the standard
deviation of the returns of a portfolio.
The Treynor ratio measures the excess return per unit of market risk in an individual investment asset
or a portfolio of assets. In other words, the Treynor ratio is similar to the Sharpe ratio, with the difference
that the Treynor ratio uses beta or systematic risk as the measure of volatility instead of standard
deviation or total risk. Treynor ratio is a more appropriate approach when an investor holds a welldiversified portfolio and the unsystematic risk of investment is diversified away. This ratio is defined as,
T= RP - Rf
(6)
P
where RP is the return of a portfolio of assets, Rf is the risk free rate of return, and P is the beta or
systematic risk of a portfolio of assets. Like the Sharpe ratio, the higher the Treynor ratio, the better the
performance of the portfolio.
Pilotte and Sterbenz (2006) explored the risk-returns characteristics of two equally weighted portfolios
of bills and bonds by applying both ex-ante and ex-post Sharpe and Treynor ratios. We follow the same
methodology in this study to measure the ex-post Sharpe and ex-post Treynor ratios of these portfolios.
The ex-post Sharpe ratio proposed in their study is,
Ex-post Sharpe ratio= 1/T t t=1 XRt ,
SD (XRt)
where XRt is the excess return of the portfolio and SD (XRt) is the standard deviation of XRt. Hereby, we
rewrite the equation as,
6

Ex-post Sharpe ratio= 1/Ttt=1(Rp,t Rf,t) ,

P,t

(7)

,t

where Rp,t is the average return of portfolio at the end of time t; and Rf,t is the avearge risk free rate at the
end of time t.
Furthermore, the ex-post Treynor ratio is rewritten as,
Ex-post Treynor ratio= 1/Tt t=1(Rp,t Rf,t) ,
(8)
p,t
where is the average for the portfolio at the end of time t.
Jensons alpha is another risk-adjusted measure used in this study to determine the abnormal returns
of these portfolios over the theoretical expected rates of return. According to Jenson (1967), the equation
of Jensons alpha is,
p = Rp [Rf+p.(RM-Rf)]
And, the ex-post Jenson alpha is as,
Ex-post Jenson alpha = 1/Ttt=1[Rp,t + p.(RM,t Rf,t)] , (9)
If a portfolios's return is even higher than the risk adjusted return, that portfolio is said to have positive
alpha or abnormal returns.
According to Fama & MacBerth (1973) and Ross, Westerfield and Jaffe (2010), the beta () of a stock
is the relation of its returns with that of the financial market as a whole that is defined as,

Cov ( R i , R m )
(10)
im2
Var ( R m )
m
where im represents the covariance between the stock and the market, and 2 m represents market
variance. To calculate the beta of each portfolio, we have computed the average covariance of the
monthly rates of return of the portfolios and the rates of return of S&P 500 EWI, then divided them by the
variance of the returns of S&P 500 EWI during the study period.

4. Research Results
4.1. Mean-Variance analysis
Table 1 shows the mean of all the four portfolios constructed as well as the mean of the S&P500 EWI are
negative within the study period. Long-term speculators holding these portfolios incur loss due to the
average negative rates of returns. However, the portfolios of LEAPS calls have generated significantly
greater negative rates of return and loss relative to the stock portfolios. Since the mean of the stock
portfolios are greater (or less negative) compared to the mean of the LEAPS calls portfolios, the longterm speculator holding the portfolios of LEAPS calls have experienced much more loss within this
period. The greater negative rates of return of the portfolios of LEAPS calls are consistent with the
theoretical prediction concerning the effect of leverage that magnifies both the positive and the negative
rates of returns. As, the average rates of return of the underlying stock portfolios were negative in this
study, leverage magnified the negative rates of return for the portfolios of LEAPS calls.
It is significant to note that the mean of the LEAPS calls portfolio with low BTM ratio is significantly
smaller (or more negative) relative to the portfolios of LEAPS calls with high BTM ratio. The portfolio of
LEAPS calls with low BTM ratio can create the greatest negative mean return and loss in comparison to
other portfolios.

Table 1: Summary Statistics of Risk and Return Tradeoff, Jan 2008 Dec 2010
Stock portfolio
with High BTM

LEAPS portfolio
with High BTM

Stock portfolio
with Low BTM

LEAPS portfolio
with Low BTM

S&P 500 EWI

Mean of monthly rates of return

-20.18%

-123.54%

-21.59%

-281.14%

-18.31%

Standard Deviation of returns

16.06%

77.57%

18.01%

244.03%

14.52%

Highest Return

6.19%

-16.25%

6.31%

31.42%

3.07%

Lowest Return

-49.54%

-308.37%

-58.38%

-804.35%

-51.12%

33

36

35

35

35

Number of months returns are

positive
Number of months returns are
negative

Table 1 also shows that the standard deviations of the LEAPS call portfolios are significantly greater
that those of the stock portfolios and the S&P500 EWI. The LEAPS call portfolios are more volatile and
risky than the stock portfolios. Although it is expected that the higher level of risk yields the higher level
of return, this expectation is not realized for the portfolios of LEAPS calls i.e. the portfolios of LEAPS
calls show higher level of risk for lower level of returns. Therefore, the performance of portfolios of
LEAPS calls in mean-variance terms is worse than those of the stock portfolios.
Figure 1 illustrates the probability distribution of monthly returns of the portfolios. As shown below
the results indicate that the returns of the portfolios are not normally distributed and they are negatively
skewed. The results of the distribution of returns show that the means and standard deviation of returns
for the stock portfolios and the S&P500 EWI are approximately in the same range. However, the
variation in the means and standard deviation of returns of the LEAPS call portfolios are significantly
greater than those of the stock portfolios. The means of the LEAPS call portfolios vary between -1.23 to 2.81 percent and the standard deviations of their returns fluctuate between 0.77 to 2.44 percent. This
implies that LEAPS portfolios are more risky and volatile relative to the stock portfolios during the
period. The standard deviation of returns for the portfolio of LEAPS call with low BTM ratio deviates
much more than that of the LEAPS call portfolio with high BTM ratio.
Figure 4.2.1 Normal Distribution of the Portfolios Returns

The results indicate that the stock portfolios have lower negative rates of returns and less volatility
relative to the portfolios of LEAPS calls. The mean of the monthly rates of return for the portfolio of
LEAPS calls with high BTM is about 6 times and for the portfolio of LEAPS calls with low BTM is
approximately 14 times smaller (or more negative) than the stock portfolio with high BTM ratio. Also,
the portfolio of LEAPS calls with high BTM ratio is 6 times and for the portfolio of LEAPS calls with
low BTM is about 14 times more volatile or risky than the portfolio of stocks with high BTM ratio.
Therefore, the performances of the stock portfolios, particularly the stock portfolio with high BTM ratio,
have been better than those of the LEAPS call portfolios during the study period. The portfolios of
LEAPS calls show the worse performance in terms of return and risk. This means that long-term
speculators holding the portfolio of LEAPS calls would acquire a larger amount of risk and lower level of
return.
4.2. Risk-adjusted performance of the portfolios
4.2.1 Sharpe Ratios
As can be observed from Table 2, the Sharpe ratios of all the portfolios as well as the S&P 500 EWI
were negative. In fact, the negative Sharpe ratio of these portfolios is the result of the negative rates of
return within the study period. There are situations like this in which portfolios generate negative excess
returns when the portfolios returns are even less than the returns on T-bills. The negative excess returns
of the portfolios result in negative Sharpe ratios for the funds and the investment portfolios.
Table 2: Ex-Post Sharpe Ratio, Jan 2008 Dec 2010
Stock portfolio
with High BTM

LEAPS portfolio
with High BTM

Stock portfolio
with Low BTM

LEAPS portfolio
with Low BTM

S&P 500
EWI

Ex-Post Premium

-0.226902

-1.26052

-0.241023

-2.836459

-0.208225

Ex-Post Sharpe Ratio

-1.4128

-1.6250

-1.3383

-1.1623

-1.4340

Modified Ex-Post
Sharpe Ratio

-0.03644

-0.97780

-0.043408

-6.921878

-0.00112

Generally, the negative values of Sharpe ratios indicate loss, but negative values of Sharpe ratios here
are difficult to interpret. Israelsen (2004) proposed a modification to the Sharpe ratio when the excess
returns are negative. He introduced an exponent to the denominator. This exponent is made up of the
excess return divided by its absolute value. The equation of the modified Sharpe ratio is as follows,
Smod = RP - Rf
(11)
^((R - R )/abs(R - R ))
P p f
p
f
By applying the modified Sharpe ratio, the numbers are more meaningful to interpret. The higher
modified Sharpe ratios of the portfolios of stocks relative to the portfolios of LEAPS call indicate that
they are better investment alternatives for long-term speculators in terms of reward per unit of total risk.
Additionally, as the modified Sharpe ratio of the portfolio of LEAPS call with high BTM is significantly
higher than that of the portfolio of LEAPS call with low BTM ratio, the former is considered a better
investment alternative relative to the latter for long-term speculators.
4.2.2 Treynor Ratios
Like the Sharpe ratios, the Treynor ratios of three portfolios, that is, stocks with high BTM, stocks
with low BTM and LEAPS call with high BTM have taken negative values (refer to Table 3). As these
portfolios have negative excess returns and positive betas, their Treynor ratios become negative.
However, one portfolio, that is, the portfolio of LEAPS call with low BTM ratio, has a positive Treynor
ratio but this is due to its negative excess return and negative beta. As such, it is impossible to interpret
the Treynor ratios of all these portfolios and rank them accordingly. In practice, the Treynor ratio is not
applicable for a portfolio with negative betas and negative excess returns as it attributes a positive
performance to the portfolio although it has negative returns. To address this issue, Kothari and Warner
9

(2001) consider solely Jenson Alpha in their comprehensive study to measure the excess returns of mutual
funds.
Table 3: Ex-Post Treynor Ratio and Ex Post Jensons Alpha, Jan 2008 Dec 2010
Stock portfolio
with High BTM

LEAPS portfolio
with High BTM

Stock portfolio
with Low BTM

LEAPS portfolio
with Low BTM

S&P 500 EWI

Beta

1.0532

0.8470

1.1350

-0.9877

1.0730

Ex-Post Treynor Ratio

Ex-post Jensons
Alpha

-0.2155

-1.4882

-0.2123

2.8716

-0.1941

-0.0076

-1.0842

-0.0047

-3.0421

0.01520

As shown in Table 3, the values of Jensons alpha for all the four portfolios are negative. This
indicates that the returns of these portfolios are lower than the expected returns. The Jensons alpha
values of the portfolios of stocks are significantly higher (or lower negative) than the portfolios of LEAPS
call. In fact, none of the portfolios beat the market during the study period, but the stock portfolios
experience higher average returns given the portfolios betas. Particularly, the portfolio of stocks with low
BTM ratio provides higher (or less negative) return given its level of systematic risk compared to the
other portfolios.
4.3. T-test for Mean
In this study, Pearson paired samples T-test was run to determine whether there is a significant difference
between the mean values of every two portfolios rates of return. The null hypothesis is supported when
the difference in mean values is zero. All paired portfolios were compared as follows;
There is no difference between the mean returns for the portfolio of stocks with high BTM and the
portfolio of LEAPS call with high BTM.
(H0: r1 r2 = 0
Ha: r1 - r2 0)
There is no difference between the mean returns for the portfolio of stocks with low BTM and the
portfolio of LEAPS call with low BTM.
(H0: r3 r4 = 0
Ha: r3 r4 0)
There is no difference between the mean returns for the portfolio of stocks with high BTM and the
portfolio of stocks with low BTM.
(H0: r1 r3 = 0
Ha: r1 r3 0)
There is no difference between the mean returns for the portfolio of LEAPS call with high BTM
and the portfolio of LEAPS call with low BTM.
(H0: r2 r4 = 0
Ha: r2 r4 0)
There is no difference between the mean returns for the portfolio of stocks with high BTM and the
portfolio of LEAPS call with low BTM.
(H0: r1 r4 = 0
Ha: r1 r4 0)
There is no difference between the mean returns for the portfolio of stocks with low BTM and the
portfolio of LEAPS call with high BTM.
(H0: r3 r2 = 0
Ha: r3 r2 0)
Table 4: T-test for differences in means

r1 r2
r3 r4
r1 r3
r2 r4

Difference in
two means
-103.36
-259.55
-1.41
-157.6

Standard
error
13.221
40.782
4.022
42.677

t-value
-7.818
-6.364
-0.351
-3.693

10

p-value
(Significance level)
< 0.0001
< 0.0001
0.727
0.004

Results
Reject H0
Reject H0
Accept H0
Reject H0

r1 r4
r3 r2

-260.96
-101.95

40.76
13.272

-6.402
-7.681

< 0.0001
< 0.0001

Reject H0
Reject H0

The results of the t-tests show that the null hypotheses are rejected and there are significant differences
between the means of stock portfolios and those of the LEAPS call portfolios. The difference between the
means of two portfolios of stocks with high BTM and LEAPS call with high BTM as well as the means of
two portfolios of stocks with low BTM and LEAPS call with low BTM are significantly different because
the p-values are less than 0.0001. Moreover, the difference between the means of two portfolios of stocks
with high BTM and LEAPS call with low BTM as well as the means of two portfolios of stocks with low
BTM and LEAPS call with high BTM are significantly different.
4.4. Research Findings
The results of our study show that the returns of the portfolios of LEAPS call are significantly lower than
those of the portfolios of underlying stocks. In addition to having lower return profiles, the portfolios of
LEAPS calls have significantly higher level of volatility or risk relative to those of the portfolios of
stocks. However, it is significant to note that during the given period of study, the higher levels of risk or
volatility of the portfolios of LEAPS call are not compensated with higher levels of returns and thus,
these portfolios have provided greater loss for their holders.
Regarding the risk-adjusted performance of the portfolios, the significantly lower modified ex-post
Sharpe ratios of the portfolios of LEAPS calls compared to the portfolios of stocks indicate that lower
level of excess return have been earned per unit of risk for the portfolios of LEAPS call. However, the
calculated Treynor ratios of these portfolios are impossible to be applied and interpreted. Since the
portfolio of LEAPS call with low BTM ratio has negative beta and negative excess return which results in
a (incorrect) positive abnormal return. Moreover, the measures of Jensons alpha for the portfolios of
LEAPS calls are significantly smaller or more negative relative to the portfolios of common stocks. This
indicates that the portfolios of LEAPS calls have less abnormal returns (or higher negative excess return)
compared to the portfolios of stocks. Overall, the values of both the Sharpe ratio and Jensons alpha show
that the performances of the portfolios of LEAP calls are worse compared to the performances of the
portfolios of stocks.
Unlike the evidence indicating the main reason of substantial loss by short-term option traders is
associated with poor market timing (Bauer, Cosemans & Eichholtz, 2008), this study reveals that the
main reason of loss for long-term option traders, in the absence of requiring to market timing, is due to
leverage. On the other hand, the better performance of the portfolios with high BTM relative to the
portfolios with low BTM ratio in terms of rates of return is associated with the abnormal return of assets
with high BTM. So, the results of this study are also consistent with the findings of Fama and French
(1995) about the outperformance of stocks with high BTM.

5. Conclusion and Recommendation

During the year 2007, many financial analysts and stock market experts predicted that the US stock
market would move up and rally the following year. Based on the technical analysis, they were looking
for a bullish trend in the US stock market in 2008. They were anticipating the future prices in the stock
market would increase and market participants would obtain capital gains. According to Business News
Journal in the 20th December 2007, seven market analysts suggested investors put their money in US
stock markets in 2008 to enjoy high profitability. Our aim is to examine the strategy of "Buying In-TheMoney LEAPS Calls vs. Purchasing Stocks" in practice rather than theory when the market is expected to
be bullish. As such, the portfolios in this study are constructed at the beginning of 2008 since the best
time to purchase LEAPS calls is when the underlying market is expected to move upward and provide
higher returns on investment. However, unlike what was expected by the stock market analysts, the year
2008 was a terrible year for most equity investors. In fact, the financial/credit crisis caused a downturn in
consumer and business spending in the year which was subsequently reflected in equity markets. The

11

sudden fall in stock prices in 2008 resulted in significant losses for the markets participants. This
downward trend in the US stock market continued throughout 2009.
Accordingly, the results of this study show that all the four portfolios of stocks and LEAPS calls have
experienced significant negative rates of return within the given study period, resulting in significant
losses for their holders, particularly the portfolios of LEAPS calls. Apart from the last observation (in
December 2010) when the stock portfolios and S&P 500 EWI turned to yield positive rates of return, the
other prior observations of the study showed negative rates of return for the portfolios. This is due to the
worsening of the US general economy during the period and abrupt downturn in the stock markets.
Within the study period, the portfolios of LEAPS call have had significantly lower rates of return and
higher risk and lower performances relative to the portfolios of common stocks. This indicated that
investing on LEAPS calls rather than underlying stocks is not a good strategy in all market situations.
Obviously, when stock prices are falling and the market is expected to be bearish, this strategy does not
work well and would result in unsatisfactory results by providing lower rates of return (or negative rates
of returns) and higher risk. Although in 2007 it was predicted that the market will improve in the future
and the general economy is providing positive signal about the future prospects of the market, things
turned out adversely and the market moves downward. In such situations, by adopting this strategy, the
long-term speculator who had expected to obtain significant gains and earning huge profits would incur
much more losses by purchasing LEAPS calls instead of common stocks.
Therefore this strategy is highly risky as we cannot exactly ensure the doom or gloom of the market. It
is feasible that the market sometimes follows some irrational patterns which cannot be predicted through
existing market analysis. As such, it is suggested that risk-averse investors or risk-averse long-term
speculators with low level of risk tolerance avoid this strategy and not replace common stocks with
LEAPS calls in their investment portfolios.
However, there are investors or speculators who are ready to take on higher level of risk on their
investments. These risk-seekers or risk lovers are aware of the possibility of losing their capital in the
market but still have the preference for taking risk. This group of investors or long-term speculators may
prefer to hold the portfolios of LEAPS calls for much longer period of time and enjoy favorable market
movement in the future. As the portfolio of LEAPS calls with low BTM is more volatile than the
portfolio of LEAPS calls with high BTM, the former can yield higher negative rates of return if the
market turns downward. Thus, we suggest that risk-seeking investors or long-term speculators hold
LEAPS calls with high BTM rather that LEAPS calls with low BTM. The portfolio of LEAPS calls with
high BTM is less volatile than the portfolio of LEAPS calls with low BTM and at the same time it can
earn higher rates of returns relative to a stock portfolio in a market upturn.
5.1 Limitation of the Study
The major constraint of this study is that we could not investigate both market upturn and market
downturn simultaneously within the study period to get a comprehensive and conclusive result from
applying the strategy of "Buying In-The-Money LEAPS Calls vs. Purchasing Stocks" in both market
conditions. Based on the behavior of the US stock market during the investigation period, the study is
only limited to the market downturn or the bearish market, not a bullish one.
This is due to data constraint, which is another limitation of the study. The primary data on LEAPS is
not distinctively available on Bloomberg and many other financial data providers. Although the financial
databases provide data on options, they do not differentiate LEAPS from standard or short-term options.
This fact makes it impossible to distinguish between LEAPS and short-term options and consequently
find the required data on LEAPS calls. The only database possessing the historical data on LEAPS in a
classified manner is the historical option database of CBOE. However, this database also does not provide
customized data on LEAPS to customers for different requirements. The historical data on LEAPS are
offered to all individuals in a uniform format. As it is not certain that the data extracted would be exactly
the ones that can be used in the study, it makes matters more challenging when working with this
database and extracting data from it. The database provides the trading data associated with LEAPS for

12

each symbol but it does not offer any information about the issuance date, expiry date and strike prices of
LEAPS before purchasing the data. As the data cannot be customized before purchasing, the risk of
collecting wrong data and incurring large costs in purchasing data is high. Considering all the challenges
of dealing with this database and associated costs of collecting the required primary data, we could not
extend the duration of the study more than three years.
Another limitation of this study is that we have ignored transaction costs in the calculation of rates of
return. However, transaction cost was only incurred one time in the study period for rolling the LEAPS calls
over and the strategy of buy and hold is applied. However, for any extension of the study using longer period
of time, for instance 5-10 years, the transaction costs should be included into the calculations.
5.2 Suggestions for further research
Areas that this study is not able to explore may provide fruitful avenues for future research. This
study is the first step in investigating the feasibility of replacing LEAPS calls with stocks in practice. As
this study could only capture the market downturn, further studies can accomplish the results of this study
by providing a comprehensive insight for both market upturn and downturn. As such, it is suggested that
a similar study be carried out in another time frame and also repeat it within a longer period of time.
5.3 Implications
The results of this study will give the investors, long-term speculators and funds managers a practical
insight about the performance of LEAPS calls against common stocks and the possible gains or losses
that they will likely experience in the financial markets. The findings of this study show that investors or
long-term speculators have to be very careful about trading LEAPS calls and replacing them with
common stocks. Although there are several suggestions (Roth, 1994; CBOE, 2001; McMillan, 2002; OIC,
2008) that buying equity LEAPS calls rather than common stocks is a good substitutes for the underlying
common stocks in the market and Thomsett (2009) call it wise and a more conservative approach to buy
LEAPS calls as an alternative to simply buying common stock in a volatile stock market, this study
empirically represents results to the contrary. If investors or long-term speculators buy LEAPS calls in the
situation when the market suddenly moves downwards, they will incur large losses.
Referring to the claims made by many financial advisors and option specialists (Finnegan, 1977;
McMillan, 2002; Taylor, 2008; Rahemtulla, 2009, Zigler, 2010) as well as that of the CBOE about the
ability to earn higher returns and lower risk relative to the underlying stocks by constructing the portfolio
of investment with LEAPS calls rather than stocks, the LEAPS call portfolios can generate lower average
rates of returns in the market. Thus, LEAPS long-term expiration of them does not mean that it is a
conservative instrument and they are still highly risky securities to be traded.

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