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Financial Literacy

Trading LEAPS Options: The Most Profitable Five-Letter Word In Options

Trading LEAPS Options: The Most Profitable Five-Letter Word In Options

By Karim Rahemtulla, Advisory Panelist
Monday, October 9, 2006: Issue #360

I think trading LEAPS options is one of the smartest, most cost-effective ways to buy stock – and anyone who tells you otherwise probably doesn’t know exactly how powerful this method of trading can be.

It forms an integral part of my investment strategy because it provides me with low-cost diversification that I might not ordinarily be able to afford. After all, how many stocks can you own if you have limited investment funds?

Three Key Benefits of Buying LEAPS

LEAPS (Long-Term AnticiPation Securities) are options that have longer-term expiration dates – up to one, two, or three years in advance. There are three key benefits of buying LEAPS:

  • They allow you to control underlying shares at a greatly reduced cost. For example, the cost of a LEAPS option bought at a strike price close to where the shares are trading usually costs no more than 15% of what it would cost to buy shares outright – and often less than 10% of the underlying share price. In addition, LEAPS can actually return you more than the underlying shares in real and dollar returns if the underlying shares move in your specified direction.
  • Because they’re long-term options, you have more time on your side for the underlying asset to increase/decrease in value (depending on what you want it to do). You don’t have to be right in days or weeks like short-term traders – you just need to get the direction right, and you’ll be in the money.
  • You spread your risk over a longer period of time and limit your potential loss. The most you can lose is what you have at risk in the option – that is, the price you paid. This is always less than the 20% or 25% stop loss typically used by traders on a stock.

Beat The Shareholders And Pocket Bigger Gains In Less Time

LEAPS are basically proxies for stocks that I want to own. My anticipation is that these companies will make strong moves either up or down in the coming months. But using a LEAP option strategy allows me to control the shares for less, and give me the benefit of time for the asset to rise.

For example, let’s say one of those talking heads on television boldly proclaims that a stock is headed for a 30% rise. No matter what the broader market is doing, that’s a pretty ambitious move. Not to mention the fact that you could be laying out a lot of money to buy shares outright, and be waiting a long time for the move to happen.

But here’s the thing: If you trade LEAPS options on the underlying shares instead of buying stock, the company doesn’t have to move up by very much (and certainly not by 30%) before you’re making money. Far from it. In fact, you can make considerably more than shareholders – you just need the share price to move in the right direction for a few days or weeks to clean up.

Let me give you a real-life example from my LEAPS Trader service…

How To Turn 3% Into 30%

A while back, I advised my readers to buy LEAPS on General Electric. At the time, shares were trading for $30, and we bought the $32.50 LEAPS.

Within three days, the shares moved to $30.90 – a whopping 3% gain for shareholders.

However, we cashed out of our LEAPS for a 30% gain in three days.

So how did the LEAPS rise that much higher, despite such a small move in the share price? The answer lies in the time-value component of the options-pricing model.

It goes something like this: If the stock can move up 3% in three days, it can keep climbing at that pace for a couple of weeks. And if it does, it could rise to, say, $33 or $34, and the LEAPS option would then be worth more.

That’s because the market, if it senses such a surge in the stock price, re-prices the option accordingly. Thus, the more time left until the option expires, the more it will cost… and the more you will get for it when you sell.

A few weeks later, we did the same thing with a defense stock. The underlying shares moved up about 4%, and we made 36% in less than a week.

In both cases, the shares did not even approach the strike price on our LEAPS – yet the options made us a ton of money.

Your 4-Step LEAPS Checklist

There are several rules you should keep in mind when considering LEAPS options:

  • Use LEAPS as a proxy for expensive stocks that could lose you a lot of money if something goes wrong (even huge companies like Merck aren’t immune from quick and ugly price slumps. Shares dived some 40% in the aftermath of the Vioxx debacle).
  • Only use LEAPS when you outlook is less than 2 to 3 years since LEAPS options are only valid for that period of time.
  • Use LEAPS for riskier strategies, such as betting that shares will fall. Shorting stocks has unlimited downside potential, and LEAPS give you a better, more cost-effective way of doing the same thing.

For example, in my LEAPS trading service, we recently shorted Hilton Hotels using LEAPS, and walked away with 15% to 20% profits within a couple of weeks. The benefit of doing this versus shorting the stock is obvious. Using two-and-a-half year in-the-money LEAPS, our risk was about $2.40. But shorting the shares directly would have put us on the hook for $26 per share.

  • Use LEAPS to diversify your portfolio at lower cost. You can control a million dollar stock portfolio for two years for about $100,000 using a LEAPS-based portfolio.

For example, I once advised traders to go long on Sun Microsystems (Nasdaq: SUNW). But instead of paying $4 a shares, we chose to pay $0.75 for a two-year LEAPS contract – nearly 85% less. It also gave us time and limited our losses to the amount we had at risk. If we’d bought the stock and used a 25% trailing stop or stop loss, we would have risked more. I chose the $5 strike price, and I was looking for the shares to move just 10% to 20% within a few months to make some good money – and with a tech stock like SUNW, which had traded within a 40% range annually over the past few years, it was a sound bet. It paid off. We just closed out our SUNW position for a 60% gain, in a staid market. Unless you’re planning on buying shares and holding them for more than a year or two, I believe you’re putting too much money at risk up front by buying large blocks of shares.

Using LEAPS = Comfortable Investing

One of the most comforting aspects of investing using a LEAPS strategy is the ability to withstand all manner of negative events and still live to fight another day.

Most recently, two of our LEAPS positions were hit hard. Back in late July, we got knocked on our Advanced Micro Devices (NYSE: AMD) spread, watching the shares fall from the mid $20s down to about $17. At that point, most regular stock investors would have been stopped out.

For us, however, while we did endure some pain, the LEAPS we owned didn’t lose all of their value. That was because with so much tine left on the options, anything could have happened. And it did. AMD has since recovered to the mid $20s again, and is gaining momentum on the heels of several analyst upgrades and the company’s announcements that it would attain close to 30% of the market within two-and-a-half years. If it continue on its current track and affirms guidance in coming quarters, this position will deliver.

The second situation occurred with Israel-based Teva Pharmaceuticals. We got into this position just before the Lebanese-Israeli war. What timing! And even through Teva shares fell by 20%, our LEAPS survived nicely. Now that the hostilities have ended, Teva is on an upswing as well with better than expected earnings and improved guidance. Barring a full-fledged Israeli crisis, our Teva spread will make us money as well.

Time Is On Your Side With LEAPS Strategies

A LEAPS strategy works because time is on your side and offers you much more protection than shareholders. In most cases, we can withstand many short-term crises that would knock ordinary stock investors out of the game. And why risk 100% of your money buying shares outright when a LEAPS position allows you the luxury of paying 10% to 15% of the capital required for a position?

My point is: When you use the right type of option and the right system, you can dwarf the returns from the stock market well before the stock reaches your target.

Good Trading,

Karim Rahemtulla


About

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.

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