LEAPS vs. Stocks: An Investment Vehicle Throwdown
by Karim Rahemtulla, Advisory Panelist
Wednesday, September 9, 2009: Issue #1088
So what’s the better investment – stocks or LEAP options?
As I’ve explained in recent columns, LEAPS are long-term options that expire in one to two years or more. So it’s an effective strategy if your outlook is a couple of years ahead at most.
And the best part is that LEAPS allow you to participate in the moves of the underlying stock (either up or down), for a fraction of what it would cost you to buy the shares outright.
So let’s compare a regular stock investing strategy with LEAP options, using the following guidelines. This is purely as an example…
The Stock Strategy
Here are the initial parameters of the stock strategy example:
- Cash to invest: $1,000,000
- Stocks to hold: 20 – Buy 1,000 shares of each, priced at $50 a share
- Timeframe: Two years
- Stop-loss: 20%
- Upside target: 30% across the board over two years (from $50 to $65)
Given that we’re looking for a 30% gain from each position, our maximum profit is $300,000. And our 20% stop-loss means the maximum loss would theoretically be $200,000.
The LEAP Strategy
Basically, we’re going to replicate the parameters above using LEAP options instead of regular shares.
- Strike price: $50 for each stock
- Cost of LEAP: $6. That’s $6,000 for each at-the-money LEAP.
- Timeframe: Two years
- Stop-loss: None
- Upside target: 30% on the underlying stocks (from $50 to $65)
Based on that guide, we’ll invest a total of $120,000 in the LEAPS positions in order to replicate the share position.
So right off the bat, that’s $880,000 less than we’d shell out for the shares outright. We’ll dump it in an account that yields 2% interest per year, which will generate about $30,000.
Stocks vs. LEAPS: Who Wins?
- The Stock Portfolio: Based on the $65 target being achieved for the stocks after two years, the portfolio will be worth 30% more ($1,300,000). Remember, though, we had $1 million at risk and capped our loss at $200,000, given the 20% stop-loss.
- The LEAP Portfolio: With each stock sitting at the $65 target price, each LEAP option is worth $15 – a 150% gain from the $6 we paid for each contract.
The combined portfolio would thus be worth $300,000 at expiration – a “net gain” of $180,000 ($300,000 minus the $120,000 we originally invested). But in fact, the actual return is even higher, since we received $30,000 by using the cash we didn’t spend on the stock portfolio to generate income for us. So our actual net outlay has dropped to $90,000 in order to make $210,000 net.
And as for the most we can lose… well, it’s capped at $90,000 – a far cry from the $200,000 at risk in the stock portfolio.
So the question you have to ask yourself, based on the above example, is whether you want to spend $1,000,000 and risk $200,000, or spend $90,000, with your risk also capped at that amount. Your answer will determine whether you are a LEAPS investor or not.
Karim Rahemtulla
Related Investment U Articles:
- Protecting Stock Profits: Here’s the Breakdown of the Ultimate “Safety Net” Trade
- Three Ways to Safeguard Your Investment Portfolio
- Potentially Grab Portfolio Gains Without Buying Shares or Risky Options
- LEAP Option Investing: Know These Five Factors Before Using This Strategy
- LEAP Option Spreads: Tame the Market With This Risk-Blasting Strategy
7 Responses to “LEAPS vs. Stocks: An Investment Vehicle Throwdown”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
If the underlying stock jumps in price, and the time horizon remains the same (say two years), a leap can be used for selling covered calls. The premium received can actually reduce the risk related to the investment. So, it is wise to monitor the held leaps, and use them as a potential candidates for this strategy. The other side of the coin is that, for stocks that pay a good dividends, you’re not allowed to receive them. If regular income is a concern, this strategy is less interesting.
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One thing I dont understand how did the leaps go from 6 to $15 150% increase Whereas the stock went up 30%. Why wouldnt the leaps also go up 30%? Tom Skouros
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Mr Skouros,
Because the price of the LEAP is equal to the share price minus the strike price. So if the stock price is 65, and the strike price is 50, the options would be worth at least $15/share. Since they were bought at $6/share, the profit is ($15-$6)/$6, or 150%.
But, in the real world, option prices are also determined by volatility, which can make the options worth a lot more, or a lot less.
That is why professionals quote prices in terms of volatility, ie “I bought this call at 25%, and I sold it at 45%”. Since option professionals aren’t aiming to make directional predictions, they hedge their positions, so quoting in terms of volatility reflects the actual cost of their position, ie a call option is trading at $1.50 with the underlier trading at $42.05. The implied volatility of the option is determined to be 18.0%. A short time later, the option is trading at $2.10 with the underlier at $43.34, yielding an implied volatility of 17.2%. Even though the option’s price is higher at the second measurement, it is still considered cheaper on a volatility basis. This is because the underlier needed to hedge the call option can be sold for a higher price.
Hope this help,
Douglas
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I’m impressed. I’ve heard about LEAPS and the less money that’s needed but I need to know more.
I need a course on trading LEAPS.
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My experience is that it is very difficult in a rising market to buy ATM LEAP with 2 years time value for 12% of the underlying value (ie $6 on a $50 stock). Can you give a real example. Thanks.
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In the given example, the LEAPs approach only gained $210,000, while the stocks gained $300,000. Karim didn’t buy enough LEAPs!
He should put $200,000 into LEAPs and $800,000 into fixed income. That way he makes more than $300,000, but not much more. And he’s risking $32,000 less.
If 12% is realistic…
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Does anyone at the Oxford Club teach options? If so how much is the course.
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