March 6, 2019

LEAPS Options

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Do you have the patience to withstand the stock market for the long-term? What if you didn't have to tie up thousands of dollars but could mimic the results of a long-term investment? It's possible with LEAPS options contracts.

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Just like their shorter-term counterparts, they aren't without risk. The wrong investment could wipe out your portfolio. The right investment could be profitable, mimicking the success of investing directly in stocks.

Keep reading to learn what LEAPS options are and if you should consider them.

What Are LEAPS Options?

LEAPS stands for: Longer Term Equity Anticipation Securities.

In other words, they are options contracts with longer terms. They usually range between 1 and 2 years in length. You can buy LEAPS calls or puts. The basic premise is you get longer for the stock to perform the way you predicted.

Buying LEAPS Calls

You should buy LEAPS calls that are deep in-the-money. A general strategy is to choose options with a strike price at least 20% less than the current market price.

The exception to this rule is when you know a stock is very volatile. In this case, you'd want to go even deeper in-the-money.

Tips You Can Use:

  1. The further in-the-money you go, the more expensive the option's premium.

  2. When you buy a LEAPS call, your largest risk is the premium paid. If the stock doesn't increase like you thought, your contract expires worthless. You then lose the premium paid.

Generally, you'd buy a LEAPS call when you predict a stock's price will increase significantly in the next 2 years.

Here's an example:
ABC stock trades at $35 today. You buy a LEAPS call with a strike price of $28. You pay a premium of $8 for the option. Your break-even point, in this case, occurs if the stock hits $36 by the LEAPS expiration date (strike price + premium paid).

Let's say the stock does hit $36 at expiration. You would exercise your right to buy the stock at $28. You'd buy 100 shares for $2,800. You could then turn around and sell the shares for $3,600. You'd walk away with a profit of $800. However, the LEAPS contract cost you $800 ($8 x 100 shares). You walk away without a profit or a loss.

Now, if the stock went above the break-even point, you'd see a profit. Let's say it ended at $45 at expiration. You could then buy 100 shares at $28, or $2,800. You'd then sell the shares for $4,500. You'd make $1,700 - $800 (premium paid) = $900.

Now, if the stock ended at $27 at expiration, your LEAPS call expires worthless. You wouldn't exercise your right to buy the stock. You'd then face a loss of $800, the premium paid.

What If You Bought the Stock Outright?

Instead of buying the LEAPS call, you bought the stock outright at $35 per share. You bought 100 shares, so you paid $3,500. We'll now look at how each situation would have worked out compared to above:

Using the same 2-year timeframe, let's say the stock hit $36. You'd make a profit of $1 per share, or $100. This is only slightly better than if you had the LEAPS call. You walk away with $100 rather than nothing.

If the stock hit $45 after the 2 years, you'd make $10 per share, or $1,000. Comparing this to the LEAPS option, you'd make about $100 more buying the stock outright.

If the stock declined and closed at $27, though, you'd lose $8 per share, or $800. The same amount you'd lose with the LEAPS contract.

Consider the initial cash outlay.
If you buy the LEAPS call, you'd put up $800. If you bought the stock outright, you'd invest $3,500. When you buy the stock outright, you risk your entire investment of $3,500. When you buy the LEAPS call, you risk only the premium paid, or $800 in this case.

LEAPS calls help you realize a greater return on your investment while minimizing your loss.

Buying LEAPS Puts

Buying LEAPS puts is like buying an insurance policy on something you own. Take, for instance, your homeowner's insurance. You pay a premium for protection in the event something bad happens. You hope nothing bad does happen. But, if it does, you are protected. It's the same with a LEAPS put option.

You pay for protection of your investment over the next 1 to 2 years. In many cases, it also helps encourage investors to stay in the market. Knowing that you have protection can help you panic less. It also allows you to wait out the rising and falling market prices.

You can also buy a LEAPS put when you don't own the stock. This is a short put. If the stock falls below the strike price, you can buy the stock at the current low price. You can then exercise your right to sell the stock at the higher strike price.

You'll have two break-even points, depending on what you choose:

  1. Protected LEAP Put (you own the stock):
    • Original price paid per share + contract premium price

  2. Short LEAP Put (you don't own the stock)
    • Strike price - contract premium price

What Happens When You Own the Stock?

You invest in ABC stock at $40 per share. You buy 100 shares. Your initial investment is $4,000. A month later you buy a LEAPS put with a strike price of $40. Consider this the absolute lowest price you'd accept for the stock. You pay a premium for this protection. In this case, it costs $4.00 per contract, so $400.

Your break-even point would occur when the stock hits $44 ($40 +4).

If the stock hit $44, you'd let the option expire worthless. You'd then sell the stock on the open market for $44, or $4,400. Taking off the $400 premium you paid, you'd walk away without a profit or a loss.

Now, let's say the stock hits $35 at expiration. You'd exercise your option to sell at $40. You'd receive $4,000. You paid $400 for the contract, bringing it down to $3,600. You paid $4,000 initially for the stock position; you walk away with a $400 loss.

If you didn't buy the LEAPS put, you'd have a loss of $500. You'd sell the stock for $3,500, when you initially paid $4,000. This is a simplified example. If you invested even more—say you bought 500 shares—you'd have a loss 5 times greater.

What Happens When You Don't Own the Stock?

If you don't own the stock, but buy a LEAPs put, it's a short put.

We'll still use the ABC stock at $40 per share. But this time, you didn't buy the stock. You think the price will decline though, so you buy a LEAPS put with a strike price of $40. You pay a $4 premium for this contract.

If the stock price hit $44, your contract expires worthless, just like in the above example. In this case, though, you don't have any stock ownership. Your loss is equal to the premium paid, or $400.

If the stock hit $35, though, you'd exercise your right to sell at $40. You'd buy the stock at $35, or $3,500, and then turn around and sell it for $40, or $4,000. You'd have a $500 profit. But you must deduct the $400 premium paid. Your total profit equals $100.

Obviously, for this tactic to be profitable, you'd want to buy a LEAPS put on a stock that you think will drop significantly in the next 2 years.

The Typical Use of LEAPS Puts

Generally, investors use LEAPS puts when they own the stock already. It doesn't make a lot of sense to tie up any money for 2 years for a limited profit.

LEAPS calls, on the other hand, have unlimited profit. The stock's price can appreciate significantly within 2 years. This can leave you with a lot of potential for profit. LEAPS calls allow you to invest a fraction of your capital while you wait for the market to rebound.

LEAPS puts are bets against the market. In other words, you want the market to decline. That can be a risky investment that doesn't provide a tremendous return.

The Bottom Line

In either case, LEAPS are long-term contracts. Don't enter into one if you expect a quick turnaround. Many investors leave options contracts until the date of expiration. That means tying up your money and waiting for the outcome for up to 2 years. Keep this in mind as you decide if LEAPS are right for you.

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