Stock options look like the vampires of the investing world, sure to kill you no matter how suave and sexy they seem when you meet. Most buy-and-hold mutual fund investors would grab a cross and start throwing holy water if you suggested options trading.
But they probably haven’t heard about LEAPS, which advocates say offer a way to rent stocks instead of buying them, with the prospect of enjoying years worth of stock gains for a fraction of the price.
“Why buy stock when you can lease it?” asks Frank Tirado, vice president for education at The Options Industry Council, which offers educational materials on options trading.
LEAPS stands for long-term equity anticipation securities, and they’re the same as ordinary stock options except that instead of expiring in weeks or months they are good for longer than nine months, sometimes years. Like all options contracts, a LEAP gives its owner the right to “exercise” the option to buy or sell 100 shares of stock at a set price for a given time. As of this writing, you can buy LEAPS that don’t expire until January 2019.
[Read: What Investors Should Know About Options.]
LEAPS have been around since 1990 and trade on the Chicago Board Options Exchange. To play, you need an options account with a brokerage, an easy process that mainly involves acknowledging the risks: If a LEAP expires “out of the money” — when exercising would not pay off — you can lose all that was spent on the premium to buy it. There’s no waiting longer for a recovery, as with actual shares of stock.
LEAPS are also offered on exchange-traded funds that track indices like the Standard & Poor’s 500 index and the Dow Jones industrial average, so you could bet on up or down moves of the broad market. Not all stocks have options, and not all stocks with ordinary options also offer LEAPS.
Note, though, that a LEAPS owner does not vote proxies or receive dividends, because the stock itself is owned by the seller, or “writer,” of the LEAP contract until the LEAP owner exercises.
Despite the Wild West image of options, LEAPS are actually ideal for conservative investors, says Russell Rhoads, director of education for the Options Institute, the CBOE’s educational arm.
“It’s a different crowd that’s interested in LEAP options,” he says. “Options are often equated, for better or worse, with speculative strategies. And (with LEAPS) we’re really talking about something that is more about being an investor than a speculative trader.”
[See: 8 Great ETFs That Hold ETFs.]
Instead of owning 100 shares of International Business Machines (ticker: IBM), you could own a single LEAP contract. On a recent day, it would have cost $152.60 for a single IBM share or $15,260 for 100 shares. But a LEAP giving you the right to buy 100 shares at $100 each — the strike price — anytime until January 2018, sold for just $5,550.
So if IBM went above $155.00, you could spend another $10,000 to buy the shares, sell them immediately and earn a profit on any gain above $155.50. In the meantime, that $10,000 could sit safely in bank savings or a money market fund, escaping a loss if IBM were to fall.
If IBM did not trade above $155.50 there would be no point in exercising the LEAP, and the $5,550 could be lost. But since IBM was trading at $152.60 at the time the LEAP was purchased, the chances it would go above $155.50 over the next 14 months might be pretty good. And the contract itself could be resold at any time to recover the difference between the stock price and the $100 strike price.
LEAPS are also popular with investors attracted to writing covered calls, the most common options strategy. In the traditional strategy, an investor who owns 100 shares of stock writes a call option, giving its buyer the right to buy the shares at a set price. The writer earns a premium, the price of the call option, plus the strike price if the option is exercised.
With LEAPS, the investor buys a LEAP call on the 100 shares instead of the actual shares. Then he writes the call option, promising to sell at a given price if the contract’s buyer exercises. If the buyer does exercise, the investor uses his LEAP to acquire the 100 shares to cover the call.
“What some investors do is they replace the requirement (to own the stock) with a LEAP call option, and then sell call options against it, creating what I call the frugal man’s covered call,” Tirado says.
This way the investor does not have to pay full price for the 100 shares until he knows he can sell them at a profit.
The IBM example above involves a deep-in-the-money contract that allows the LEAP owner to buy shares for far less than their current price — $100 versus $152.60. It would be much cheaper to buy a LEAP contract without so much built-in, or “intrinsic” value.
Tom Gentile, editor of Power Profit Trades, an options-trading newsletter, noted that Facebook ( FB) stock traded recently at $127, but the January 2018 LEAP with a $130 strike price cost just $16.50 a share. “You’re picking this up for a little less than 15 percent of the cost of buying and holding the stock,” he said. For the bet to pay off, the shares would have to go above $146.50 sometime before January 2018, to cover the cost of the premium and buying the shares. Anything above that would be profit.
“The cost to rent is always going to be cheaper than the cost to own,” Gentile says. A LEAP good for a year or two would be cheaper than a series of short-term options contracts.
In another strategy, a LEAP “put” can be used to hedge against loss by locking in the right to sell a block of shares at today’s price. An investor with a basket of stocks or mutual funds, for instance, could buy a put on the S&P 500 index. While it would be too costly to insure a portfolio all the time, it might be worth it during periods of great uncertainty, though premiums go up in such times.
“The cost of hedging has increased dramatically (in recent months), and that’s because of the election,” Tirado says.
While a LEAP can be considerably cheaper that buying shares, it’s generally unwise to get in too deep, Tirado says.
“The idea is if you have $10,000 if investing capital, is not to put it all in LEAPS,” he says. Instead, use 10 to 25 percent of the capital for LEAPS to control the number of shares you could afford if you bought them outright, he suggests, keeping the rest safe as cash.
[See: 11 Tips for the Sandwich Generation: Paying for College and Retirement.]
Of course, options traders need to keep on top of things to exercise when opportunity beckons. So LEAPS are no good for investors with a fire-and-forget mentality.
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How to Invest in Long-Term Equity Anticipation Securities (LEAPS) originally appeared on usnews.com
