Why LEAPS Get Crushed In A Takeover

always tell investors that a prudent option investor moves the odds in their
favor as much as possible BEFORE
they make a trade.

Many of our customers at www.ptisecurities.com
have effectively used LEAP Calls as a stock surrogate, and in that way, reduced
the risk of stock ownership as one can normally accumulate LEAP Calls for 1/10 –
1/8 of the cost of stock ownership.

wonderful as LEAPs can be to define risk and free cash for diversification into
other equities, its important to note that LEAP extrinsic premiums do suffer
greatly in the event of takeovers or mergers. For that reason, and because so
many of you have sent e-mails asking about ENE
I offer the following explanation:

of you have asked me to expand on why LEAPs see such rapid reduction in
extrinsic value when a takeover is announced.

The reason for that is both simple and elegant. The major difference between a
LEAP Call and a short-term option is TIME. The LEAP may have one or two years
before expiration vs. the short-term option that has 30 to 90 days until it

of Short-term vs. LEAPs

  1. January
    2004 LEAPS have roughly 800 days until expiration

  2. Short-term
    January 2002 options have 66 days until expiration

we could hold interest rates and volatility constant, the calculation between
the pricing of the LEAP vs. the short-term option would look like this:

= Days to expiration, I = Interest rates S = Strike price

800 (Days)
* .045 (Interest rate) * 50 (Strike price) / 360 = $5.00

66 (Days)
* .045 (Interest rate) * 50 (Strike price) / 360 = $.41

As you can see, the
TIME component makes the LEAP Call worth substantially more than the short-term
option. If a takeover occurs, investors and traders might accurately assume that
that TIME component could be dramatically reduced, as the buyer will simply
absorb the takeover target. Since various domestic and, when applicable,
international agencies must approve mergers, traders usually assume a 90- to 180-day
window depending on the complexities of the transaction.

Another potential
contributor to the crush of LEAP premiums in the event of a takeover is that the
acquirer usually has a lower volatility than that of its prey. When a deal is
announced, the target normally sees its volatility trade down to that of the

The Enron
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deal is a
textbook example of what happens when a merger is announced. Prior to the deal,
ENE LEAP Call options were trading as high as 150% volatility, reflecting the
uncertainty about the survival of the energy trader. After the weekend
announcement of the takeover, ENE volatility fell down to the 80% level. Traders
also re-assessed and re-valued the LEAPs as they saw little chance that ENE
would exist as an independent company for the next 1 or 2 years.

with this knowledge, if you suspected a takeover may be in the offing, a simple
Covered Write of the stock vs. a LEAP Call can be a fantastic investment
vehicle. In fact, option traders can frequently get wind of takeovers when large
institutional traders suddenly become sellers of LEAP Calls