Here’s a look at a less talked about option in trading… LEAPS.
Long-term equity anticipation securities (LEAPS) are publicly traded options contracts with expiration dates that are longer than one year. This is in contrast to traditional options, which usually expire within 6 months.
Put simply, LEAPS possess all the same characteristics as standard options, just with a longer life.
And with further out expiration dates, these options can be quite useful for both long-term investors and traders.
LEAPS vs. Short-Term Options
The primary difference between LEAPS and standard weekly and monthly options is time.
LEAPS allow for more time to be right about the direction of the stock And because there is more time for the predicted move to play out, LEAPS behave more closely to the underlying stock.
However, the added time value also makes LEAPS more expensive than shorter-term options.
For example, here’s a look at a 1-month call vs. a LEAP
The graphic above illustrates the result of the LEAP being more expensive than the short-term option…
Your potential maximum loss is greater and your break-even point will be farther away, so there is a balance between the value of the added time and the increased up front cost
LEAPS In LIEU of Stock Ownership
Since they cost less than buying the stock and tend to move in step with the price… you can capitalize on your trading decisions without tying up all your capital in the stock.
Assume you believe a stock will go up in price over the next couple of years. Instead of purchasing the stock, you might decide to buy a 2-year LEAPS option.
Here’s why:
- Options can enhance return. LEAPS allow you to control a greater number of shares with less money.
- The potential loss of the trade may be reduced. The maximum loss when purchasing LEAPS is the cost of the option. Whereas the max loss when buying stocks is the result of the stock going to zero.
These benefits might make LEAPS an attractive choice if you can manage risk properly.
Here’s an example of how a LEAPS call option can increase your return. Theoretical example for simplicity:
- XYZ is $50/ share. 100 shares = $5000
- LEAPS = $7 = option to control 100 shares is $700
- XYZ goes to $60/ share. 100 shares = $6000 = +20% return
- LEAPS now = $10 = $1000 for your contract = +42% return
- XYZ now goes to $65/ share. 100 shares = $6500 = +30% return
- LEAPS now = $15 = $1500 for your contract = +114% return
As you can see, the LEAPS contract returns a higher amount if you are right.
Amplify Your Return
Instead of dumping all of your capital in contracts and hoping for the best. Look at how to amplify your return without risking your whole account.
LEAPS are well suited to increase your return by putting the bulk of your money in the stock or index and using a small portion in LEAPS contracts.
- $5,000 total investment
- 72 shares of stock at $50 = $3,600 + 2 LEAPS contracts for $1,400
- At $60/ share you can see the LEAP begins to magnify your return = 26.4% vs. a stock only return of 20%. And it takes off from there.
- At $75/ share the return jumps to 108% vs. the stock only return of 50%
With this strategy you will take on a risk of $1400 should the LEAPS expire worthless. This is due to the premium you pay up front. The risk however also gives you the opportunity for a much greater gain.
By using a mixture of buying the stock in conjunction with LEAPS, you can limit the risky side of using LEAPS alone… while also receiving the benefits of increasing your gains when you are right.
HEDGING
Besides the traditional speculative options trading, LEAPS can be an effective tool for hedging. As a long term investor, you can buy LEAPS puts to hedge against a long position.
Buying puts can help you hedge against a decline in the stock or index over time. You may be long a stock that has appreciated in value, but are worried about a decline in the short term.
Of course you don’t know when it will happen, so you don’t want to sell the stock and miss any more potential appreciation in the meantime. With this in mind, you can buy LEAPS puts as a hedge against a potential price decline.
With LEAPS you don’t have to be precise with the timing of the downturn because of the long time frames it offers. Short-term options however create a need to be more precise with your timing.
The purchased put essentially locks in some of the unrealized profit, less the cost of the option.
Suppose you purchased 500 shares of XYZ at $10 per share. Several months later the stock is trading at $30 per share.
You still want to own the stock long term. However you are concerned about a decline in the next year or two. Consider LEAPS puts to lock in the gains.
This could be done, for instance, by purchasing 5 XYZ on year 30 strike price LEAPS at 3.6 for a total of $1800 (3.6 x 100 = 360 per contract x 5 contracts =$1800).
If the stock were to rise to $50, the put would expire worthless, resulting in a loss on the LEAPS contracts of $1,800 (the cost of the option). The total profit however would be $18,200 ($10,000 from the price increase – the $1,800 option premium).
If the stock had gone down to $20, you would be able to sell at $30 for a profit of $8,200 ($10,000 from the sale at $30 – $1,800 premium). Whereas if you didn’t have the LEAPS contracts, you would be selling at $20 for a profit of $5,000.
The $1800 premium let you lock in profit at the same time as allowing you to continue to profit from increases in the stock price. And protect you from a major sell off.
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Source: PetraPicks.com | Original Link
