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Fair Warning: LEAPS Can Go POOF!

Fair Warning: LEAPS Can Go POOF!

I learned about one risk of buying LEAPS the hard way.

LEAPS (Long-Term Equity Anticipation Securities) are options that expire in a year or more. That means they generally have a lot of time premium built into them.


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But there’s always a chance that LEAPS can go POOF.

POOF stands for “Premium Obviously Obliterated Forever” (yes, I made that up) – and I experienced this phenomenon last year.

I had purchased some out-of-the-money LEAPS on a biotech company that I liked. The good news? They got a buyout offer from another company. The bad news? It was below my strike price.

So what do you think happened to all that time premium embedded in my LEAPS? It vanished because the implied volatility of those options collapsed.

Sure, there were a few rumors about other companies who might bid more. Another few dollars per share might have made some difference, but once it became clear that the transaction would occur below my strike price, my options became virtually worthless.

Probability and time

Option values basically reflect the market’s view of the probability that the underlying stock will move – and how quickly it’s likely to do so. Implied volatility is one component in calculating this value.

But implied volatility is meaningless once those probabilities become certain. Time makes no difference either. Whether your option expires in 100 days, 1 year, or even 10 years, nobody’s going to pay much for it when it’s almost certain to be worthless.


Here’s a totally hypothetical scenario: Let’s assume that Citrix Systems (CTXS), a technology company, gets a buyout offer for $58 per share. Here’s a chart showing how the stock has been trading:



Sure the stock would pop – probably to somewhere near $58 per share. Now take a look at the LEAPS options that expire in January 2012 (as they traded on July 19).

If it became clear that Citrix was inclined to accept that hypothetical $58 offer, how would these options trade going forward?

Well, those $60 calls would likely plunge from about $2.75 to almost nothing. Even the $55 call options probably wouldn’t be worth much more the $3.00 difference between the $55 strike price and the hypothetical $58 offer.

So before you buy out of the money LEAPS, consider what would happen if all that time premium went POOF!