Supersize Your Market Potential with LEAPS Options
by Karim Rahemtulla, Advisory Panelist
Tuesday, September 1, 2009: Issue #1081
Investing in options means speculating, right? A hit-and-miss approach to the market?
Sadly, that’s what some options naysayers would like you to believe – and if you do, let me set the record straight…
Investing in anything carries a certain amount of speculation – be it stocks, options, coins, fine art, or any number of other things.
Over the past decade, for example, we’ve seen that even investing in some so-called “safe” blue-chip stocks has proved to be a speculative bet. In fact, it’s carried greater financial risk than investing in LEAP options could ever pose. Over the past year alone, if you had a portfolio of LEAP options in lieu of a stock portfolio, you’d have come out way ahead of the game.
The thing is, though, some “experts” scoff at the fact that owning options can actually mitigate risk. They tend to focus on the speculative aspect, volatility, risk and the perceived complexity.
They’re wrong. Listen up and I’ll show you exactly what the rest of Wall Street fails to understand – and doesn’t want you to know…
Tune Out the Skeptics… The Benefits of LEAP Options
In recent columns, I’ve highlighted the benefits of using LEAP options – long-term options that not only allow you to capture the movement of the underlying stock, but do so within a period of up to three years. Plus, you don’t even have to own or short the shares directly.
At this point, most simpletons point out the speculative aspect. But I’d argue that the only reason why LEAPS fall into this category is because they will expire one day. However, expiration isn’t really an issue if you don’t hold them that long, or actually make money on the investment!
In truth, LEAPS fit well with a conservative investment style because it’s another tool to mitigate risk in a portfolio. Here’s how it works:
- Let’s say you think the stock market will recover in the next 18 months or so.
- To play the recovery, you want to go long on one of the market’s heavyweight blue-chip stocks like Dow Chemical (NYSE: DOW), which tends to move with economic growth.
- Dow’s 52-week trading range swings pretty wildly – from a low of $6 (as investors fled from stocks en masse earlier this year) to a high of $40. The stock is currently sitting around the middle of that range – $22.
- That means if you were to buy 1,000 shares, you’d fork over $22,000.
- Let’s say your target price is $35 by January 2011. On the downside, if you used a 25% stop-loss, you’d exit the stock at $16.50 or lower. In dollar terms, that’s a $5,500 loss.
Bottom Line: You’re willing to risk losing $5,500 in hopes of making $13,000 ($35 target minus the $22 current price = $13), or 60%.
LEAPS: Lower Cost… Lower Risk
Now let’s see how the above compares to using a LEAP option strategy…
Remember, our target time period is January 2011. Pull up the options chain for that expiration month and you’ll see that the DOW $22.50 LEAP call option (VDO-AX) is currently trading for $3.60. This is known as the strike price – the price at which you have the right to buy the shares at options expiration (of course, you could sell the option before that date).
To control the same number of shares as our stock position (1,000), you’d therefore have to buy 10 option contracts (since one contract is comprised of 100 shares). So your outlay would be $3,600 ($3.60 multiplied by 100 = $3,600).
That means you’ve got a pretty compelling twin benefit…
- Right off the bat, you can see that your total risk in this trade is $3,600, versus the $5,500 you’d be willing to lose with a 25% stop-loss on the regular stock position.
- By only risking $3,600, that’s $18,400 less than you’d have spent buying the shares outright – money you could use for other things. For example, if you put it in an account that earned 3% interest, you’d offset your LEAP option cost by $1,000 over the course of the trade.
Now for the profit potential…
Stocks vs. LEAPS
By going using LEAPS, your cost to control the DOW shares is $26.10.
We arrive at that number by simply adding the option premium ($3.60) to the strike price ($22.50).
Using the $35 target price, you can see that the potential profit is $8.20 per contract ($35 strike price minus the $26.10 cost). So for the 10 contracts (1,000 shares), that works out to $8,200 – a 190% return on your money ($8.20 divided by $4.30).
So let’s recap…
- The Stock Investment: Buying DOW shares outright means you’re looking to make $13,000 (60%)… but you have to invest $22,000 to do it, and you’re risking a $5,500 loss if the position goes against you.
- The LEAP Investment: By executing a LEAP option play, you stand to make $8,200 (190%)… but you only invest $3,600.
That’s not only mitigating your risk, but also boosting your profit potential. Perfect for any market – but particularly the current one.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.