Using LEAPS Instead of Stock to Generate Huge Returns
A Stock Option Strategy for Bullish Investors
If you are bullish on a particular company’s stock, you can structure your investment with LEAPS so that a rise of, say, 50 percent could translate into a 300-percent gain for you. Of course, this strategy comes with risks, with the odds very much stacked against you. Used foolishly, it can wipe out your entire portfolio in a matter of days. Used wisely, however, it can be a powerful tool that allows you to leverage your investment returns without borrowing money on margin.
Defining a LEAPS Strategy
The strategy consists of acquiring long-term stock options known as LEAPS, which stands for “Long-Term Equity Anticipation Securities”. Put simply, a LEAP is any type of stock option with an expiration period longer than one year. It allows you to utilize a smaller degree of capital instead of purchasing stock, and earn outsized returns if you have bet right on the direction of the shares.
An Example Strategy
It’s easier to understand how to use LEAPS by way of an example. For now, use shares of General Electric given the enormous size of the company and the fact that virtually everyone in the world knows of the firm.
Say that shares of GE are trading at $14.50, and that you have $20,500 to invest. You are convinced that General Electric will be substantially higher within a year or two and want to put your money into the stock. You could simply buy the stock outright, receiving roughly 1,414 shares of common stock.
You could leverage yourself 2-1 by borrowing on margin, bringing your total investment to $41,000 and 2,818 shares of stock with an offsetting debt of $20,500. However, if the stock crashes, you could get a margin call and be forced to sell at a loss if you can't come up with funds from another source to deposit in your account. You will also have to pay interest, perhaps as much as 9 percent depending upon your broker, for the privilege of borrowing the money.
Perhaps you don't like this level of exposure. Given your conviction, you might consider utilizing LEAPS instead of the common stock. You look to the pricing tables published by the Chicago Board Options Exchange (CBOE) and see that you can purchase a call option expiring the third weekend in January of 2011, nearly 20 months and 3 weeks away, with a strike price of $17.50.
Put simply, that means that you have the right to buy the stock at $17.50 per share any time between the purchase date and the expiration date. For this right, you must pay a fee, or premium, of $2.06 per share. The call options are sold in contracts of 100 shares each.
You decide to take your $20,500 and purchase 100 contracts. Remember that each contract covers 100 shares, so you now have exposure to 10,000 shares of General Electric stock using your LEAPS. For this, you have to pay $2.06 x 10,000 shares = $20,600. You rounded up to the nearest available figure to your investment goal. However, the stock currently trades at $14.50 per share. You have the right to buy it at $17.50 per share and you paid $2.06 per share for this right. Thus, your breakeven point is $19.56 per share.
That is, if General Electric stock trades between $17.51 and $19.56 per share when the option expires nearly two years from now, you will suffer some loss of capital. If GE stock is trading below your $17.50 call strike price, you will have a 100- percent loss of capital. Hence, the position only makes sense if you believe that General Electric will be worth substantially more than the current market price, perhaps $25 or $30, before your options expire.
Say you are correct and the stock rises to $25. You could call your broker and close out your position. If you chose to exercise your options, you would force someone to sell you the stock for $17.50 and immediately turn around and sell the shares you bought, getting $25 for each share on the New York Stock Exchange. You pocket the $7.50 difference and back out the $2.06 you paid for the option.
Your net profit on the transaction was $5.44 per share on an investment of only $2.06 per share. You turned a 72.4 percent rise in stock price into a 264 percent gain by using LEAPS instead of stock. Your risk was certainly increased, but you were compensated for it given the potential for outsized returns. Your gain works out to $54,400 on your $20,600 investment compared to the $14,850 you would have earned.
Had you chosen the margin option you would have earned $29,700 but you would have avoided the potential for wipeout risk because anything above your purchase price of $14.50 would have been gain. You would have received cash dividends during your holding period, but you would be forced to pay interest on the margin you borrowed from your broker. It would also be possible that if the market tanked, you could find yourself subject to a margin call as we warned earlier.
The Temptations and Dangers of Using LEAPS
The biggest temptation when utilizing 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 strike. You may also be tempted to take on more time risk by choosing less expensive, shorter-duration options that are no longer considered LEAPS. The temptation gains fuel from the few, extraordinarily rare instances where a speculator has made an absolute mint.
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, and have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy.
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.