How Investing With LEAPS Could Generate Huge Returns
A Risky Stock Option Strategy for Bullish Investors
You can structure your investment with long-term equity anticipation securities (LEAPS) if you're bullish on a particular company’s stock. A rise of 50% could translate into a 300% gain, but this strategy comes with risks and the odds are stacked against you. It can wipe out your entire portfolio in a matter of days when it's used foolishly.
Used wisely, however, it can be a powerful tool that allows you to leverage your investment returns without borrowing money on margin.
What Are LEAPS?
LEAPS are long-term exchange-traded options with an expiration period of up to three years. Acquiring them allows you to use less capital than if you'd purchased stock, and they can deliver outsized returns if you bet right on the direction of the shares.
LEAPS vs. Simply Buying Stock
Let's say you want to purchase several shares of Company XYZ. It's trading at $14.50 and you have $14,500 to invest. You're convinced that XYZ will be substantially higher within a year or two, so you want to invest your money in the stock. You have three options. You can purchase the stock outright, buy it on margin, or use LEAPS.
Buying on margin involves borrowing money from your broker to do so and pledging your shares as collateral for the loan. It might sound convenient, but you could ultimately lose more money than you've invested.
Buying Outright or on Margin
You could simply buy 1,000 shares of the stock outright with your $14,500, or you could leverage yourself 2 to 1 by borrowing on margin, bringing your total investment to $29,000 and 2,000 shares of stock with an offsetting debt of $14,500.
But you could be forced to sell at a loss if you get a margin call, the stock crashes, and you can't come up with funds from another source to deposit into your account.
You'll also have to pay interest for the privilege of borrowing that money on margin.
You might consider using LEAPS instead of the common stock if you don't like this level of exposure. First, you would look to the pricing tables published by the Chicago Board Options Exchange (Cboe) and see that you can purchase a call option for Company XYZ that expires two years from now, with a strike price of $17.50.
A call option gives you a defined period of time during which you can buy shares at the strike price.
This means that you have the right to buy at $17.50 a share at any time between the purchase date and the expiration date. You must pay a fee, or premium, for this option. The call options are also sold in contracts of 100 shares each.
Let's say you decide to take your $14,500 and purchase 100 contracts. Remember that each contract covers 100 shares, so you now have exposure to 10,000 shares of Company XYZ using your LEAPS. Let's say you paid a premium of $1.50 per share. That's $1.50 times 10,000 shares, or $15,000.
You rounded up to the nearest available figure to your investment goal, but the stock currently trades at $14.50 per share. You have the right to buy it at $17.50 per share and you paid $1.50 per share for this right, so your breakeven point is $19 per share.
How LEAPS Could Work
This scenario can play out in a few different ways.
- You'll suffer some loss of capital if the stock trades between $17.51 and $19 per share when the option expires in two years, and you'll have a 100% loss of capital if it trades below your $17.50 call strike price.
- You could call your broker and close out your position if the stock does rise substantially.
- You could force someone to sell you the stock for $17.50 per share and then immediately turn around and sell the shares you bought at the higher price per share if you elect to exercise your options. You'd pocket $6 per share—the capital gain of $7.50 minus the $1.50 you paid for the option—if it rose to $25.
This investment position only makes sense if you believe that the stock will be worth substantially more than the current market price—perhaps $10 or $15 more—before your options expire.
The Outcome Using LEAPS
Your net profit on the transaction would be $6 per share on an investment of only $1.50 per share. You turned a 72.4% rise in stock price into a 400% gain by using LEAPS instead. Your risk was certainly increased, but you were compensated for it, given the potential for outsized returns.
Your gain works out to $60,000 ($6 capital gain per share on 10,000 shares) for an initial investment of just $15,000. This is compared to the $10,500 you would have earned if you bought 1,000 shares of the stock outright at a share price of $14.50 and it increased to $25 per share over time.
Buying it on margin would have helped you earn $21,000, but you would have avoided the potential for wipe-out risk because anything above your purchase price of $14.50 would have been a gain. You would have received cash dividends during your holding period, but you would have been forced to pay interest on the margin you borrowed from your broker.
It's also possible that you could have been subject to the margin call if the market tanked.
The Temptations and Dangers of Using LEAPS
Using LEAPS doesn't make sense for most investors. They should only be used with great caution and by those who:
- Enjoy strategic trading
- Have plenty of excess cash to spare
- Can afford to lose every penny they put into the market
- Have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy
The biggest temptation when using LEAPS is to turn an otherwise good investment opportunity into a high-risk gamble by selecting options that have unfavorable pricing or would take a near miracle to hit the strike price.
You might also be tempted to take on more time risk by choosing less expensive, shorter-duration options that are no longer considered LEAPS. The temptation is fueled by the extraordinarily rare instances where a speculator has made an absolute mint.
The Balance does not provide tax, investment, or financial services, and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Cboe. "Long-term Equity AnticiPation SecuritiesSM (LEAPS®) at Cboe." Accessed April 20, 2020.
Fidelity. "LEAPS and Bounds." Accessed April 16, 2020.
U.S. Securities and Exchange Commission. "Margin: Borrowing Money to Pay for Stocks." Accessed April 20, 2020.
Cboe. "Delayed Quotes Table." Accessed April 17, 2020.
U.S. Securities and Exchange Commission. "Investor Bulletin: An Introduction to Options." Accessed April 20, 2020.