LEAPS: How to Add This Option Trading Strategy to Your Investment Arsenal
by Karim Rahemtulla, Contributing Editor
Thursday, August 13, 2009: Issue #1065
When it comes to investment choices, you're looking for two key elements right off the bat: Simplicity and understandability.
After all, if you know what you're doing, your chances of success are greatly heightened. And that's especially true in the sometimes confusing world of options.
For example, I often get questions from folks at seminars asking why I don't use trading strategies like butterfly spreads, condor spreads, or iron crosses.
Simple. They're too complex.
There are many options trading strategies that are much easier to execute than these and are proven to work time after time, so why complicate the issue?
I believe in keeping it simple. Even if you're an options aficionado, making a complex trade only defeats the purpose. Just because a trade is complex doesn't necessarily mean you're going to get higher profits or greater win rate consistency.
Over the last couple of weeks I've addressed covered call selling and using deep-in-the-money (DITM) options. Today, I'm going to focus on Long Term Equity Anticipation Securities (LEAPS) - options that expire anywhere from one to three years.
The Beauty of LEAPS
If LEAPS is a new term for you, don't worry. While it sounds a bit long-winded, it doesn't involve any fancy or complicated tricks. But because LEAPS are options that expire over a longer period of time, it gives investors a solid method to invest in stocks either from the long side or the short side.
LEAPS offer several advantages over common stocks and you essentially just need to adopt an outlook of less than two years... maybe two-and-a-half years at most. And given that over the past decade we've increasingly become a nation of traders rather than investors - due to immense market volatility - it's a good strategy for most people.
And since LEAPS expire in a couple of years or less, forget "buy-and-hold" stocks or "legacy" investments.
This kind of mentality has pretty much gone by the wayside since we really can't trust anything we hear from Wall Street anymore. Need I remind you of companies like American International Group, WorldCom, Global Crossing, Washington Mutual and Enron - all of which have shown us that lying is often an art form in the investment and corporate world?
Investing With LEAPS
LEAPS allow you to invest in the same company that you were going to buy shares in... but for a fraction of the cost. For example:
- Let's say you want to buy 1,000 shares of Goldcorp (NYSE: GG). At its current price, that's a hefty outlay of $38,000. And it's totally unnecessary, since LEAPS allow you to practically replicate the investment over a two-year holding period.
- You could control 1,000 shares by buying 10 options contracts (one contract consists of 100 shares of the underlying stock) at the January 2011 $35 strike price for about $9,000. That's less than 25% of the stock price.
If you're taking a bullish stance on gold and establish a price target for Goldcorp of $60 or so, here's how the profit potential breaks down...
- $60 minus $35 (the options strike price, at which you have the right to buy the shares) = $25
- $25 (gross profit) minus $9 (cost) = $16, or $16,000 in net profit.
Two more big benefits...
- If you employed a 25% stop-loss on your shares, you'd actually lose more than if you bought the option and held it for a complete loss.
- By using LEAPS, more than 75% of your money isn't tied up in the shares - money you can use for other investments.
And that's just the beginning...
Over the next few columns, I'll introduce you to several LEAPS options strategies. So stay tuned.
Today's Investment U Crib Sheet
Remember that because LEAPS are options, they don't pay dividends. Also, LEAPS may not be available on every stock due to LEAPS being a limited market. However, most large-cap, established stocks have LEAPS, including just about every stock on the S&P 500 and Nasdaq 100.
Recently, we've touched on a number of options principles and the many ways investors can profitably use them. With "Deep-In-The-Money Covered Calls" investors can lower their investment costs and their risk. And earlier this week, Karim answered some of the "Common Reader Questions on Options Investing."