Say you're anticipating an advance in the price of a stock option over the next two years, but don't want exposure to time decay issues.
LEAPS stands for Long-Term Equity Anticipation Securities. They are options contracts with expiration dates longer then one year.
The ability to buy a call/put option that expires one or two years in the future is very alluring because it gives the holder exposure to the long-term price movement without the need to invest the larger amount of capital that would be required to own the underlying asset outright.
Say stock ABC, as of December 2013, is trading at $60 a share, and a two-year LEAPS call with a strike price of $60 is trading at $5...
You could buy five of these LEAPS call contracts for $2,500, (initial cost $5) x # of shares in an options contract (100 x 5 contracts equals $2,500).
These five calls now give you the right to buy 500 shares of ABC between now and expiration at $60, no matter how high the stock rises. Your break-even point would be $65, or the strike price plus the premium paid.
Now, say your LEAPS, with a strike price of $60, soars to $75 by expiration. You have two options: You can exercise the five call contracts and own the stock by paying $60 a share, or you can exit the LEAPS position for a gain. If at the time of expiration, the stock traded at $75, you'd have a gain of about $7,500 (five contracts multiplied by 100 minus the total of your cost per contract, multiplied by the price increase of, in this case, 15).
Now, remove the premium you paid ($5) and multiply that by the number of contracts (again multiplied by 100, which gives you your contract price), which comes out to $2,500.
After removing the premium paid, your total profit would be $5,000, or about 200%. Had you bought the underlying stock at $60 and rode it to $75, you'd only have a gain of about 25%.
Confused? Take your time. It's very easy once you get the hang of it. Here's the profit difference when you exit the LEAPS call, as compared to exiting the stock.
Exit 5 LEAPS ABC 5 Call
Initial Cost ($5) x # of shares in contract (100) = $500
Cost ($5) x # of shares in contract (100) x exit price ($15) = $7,500
Profit before commission and removing premium = $7,500
Exit 500 shares of ABC at $60
Initial Cost = $30,000
If the stock rises to $75, you're profit is $7,500 (does not include commission).
LEAPS Investing: Advantageous Leverage
LEAPS strategies have many advantages as compared to just buying or short selling a stock.
- First, the option premium is typically less that the amount of cash needed to buy a stock.
- Second, since the maximum risk on a LEAP play is equal to the premium paid, you know exactly how much you could use. There's limited risk.
- Third, there's unlimited reward. Hit breakeven (strike price + premium = break-even), and your potential reward is unlimited.
If you're not a buy and hold kind of investor, why buy underlying stocks? And why bother dealing with time decay by buying nearer term options?
They're far too volatile.
But what if you just removed the time premium from the equation and hold an option for up to three years at a time? That's what you're doing with LEAPS options.
LEAPS cost only a fraction of owning a stock. And they've been known to rocket higher as the underlying price moves. Say you own a $50 stock, and it goes up $5. Your gain is 10%. But say you own the January 50 calls, for example, at $1 and the stock went up $5. You could now be sitting on a few hundred percent gains.
That's how you maximize your potential gains. Not by worrying about time decay, or making scant gains from holding overpriced stocks.
More positives for owning LEAPS:
- Your risk is known.
- You can buy LEAPS calls if you think a stock is rising. You can buy LEAPS puts if you think a stock is heading lower. There's a lack of time decay.
- You can play "big picture" trends, using commodities such as gold. Say the dollar gets weaker. Investors run to gold as a safe haven, and you own the XAU LEAPS that'll leverage your gains when gold moves in "your" direction.
Stay tuned for more on options investing tips in Wealth Daily.