Understand LEAPS and Maximize Long Term Gain Potential

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By Ian Cooper

Tuesday, February 5th, 2008

**Editors Note: In our How to Invest in Options article, we mentioned:

Theres also time value. This is any value of that option other than intrinsic. If ABC is trading at $40 and the ABC 35 call option trades at $6, then wed say it had an intrinsic value of $1 ($6 option price minus $5, or intrinsic value). This is the insurance premium of the option.

The $1 time value was accidentally referred to as intrinsic value. My apologies for the error

We also received a question asking if we ever had losers. Yep, we sure have. Weve had our fair share of losers, too, which we made sure to mention. Any one that tells you they have 100% success buying or selling stocks or options is full of it.

The purpose of the article wasnt to show off winners. It was to show that option trading can provide better opportunities than if you just bought or shorted the underlying stock. I have many testimonials thanking me for gains, but I also have those that wished me harm, to put it nicely.

While we did receive more questions, which I will answer, I wanted to educate you even further on options, this time with LEAPS.

LEAPS (Long-term Equity Anticipation Securities) are long-term options with expiration dates up to three years out that let you take long-term options positions.

But why buy LEAPS, when you could just buy the underlying stock?

It’s all about leverage. You want to make the most money you can from an investment, dont you?

Tell me. Would you rather make a 150% gain using an option, or a 35% gain buying the same underlying stock?

Its a no-brainer. Its less risky. And you know the risk.

Remembering New Century Financial

Heres an actual 2007 trade that Ill use as an example.

Sub-prime mortgage delinquencies had just nailed a four-year high in Q4 2006. According to the Mortgage Bankers Association, 13.3% of sub-prime borrowers were delinquent in their payments the highest rate since Q3 2002.

We expected it to get worse. As sub-prime exotic adjustable rate mortgages reset with higher interest rates, we forecast a sharp increase in homeowner inability to meet mortgage payments as rates on a reported $265 billion in sub-prime mortgages were scheduled for reset this year alone. We knew that some of those mortgages could reset up to 12% if the borrowers couldnt refinance.

As a result, we knew we were likely to see a continuation of delinquencies. Defaults on U.S. sub-prime mortgages, at the time, were at a seven-year high. And, at the time, more than two dozen lenders filed for bankruptcy or were about to sell their operations.

Indeed, loan defaults and foreclosures were on the rise and were likely to continue crushing sub-prime lenders. We also knew that sub-prime market would remain under considerable pressure for at least the next six months.

Before subprime mortgages began making news in February and March of 2007, we bought LEAPS on several sub-prime and Alt-A-related companies, such as New Century Financial, thinking it’d take months for the meltdown to really hit home.

At the time, New Century Financial traded above $30. Now, months after announcing it was the target of a federal criminal inquiry into the accounting and trading in the stock, warning that it will likely breach a lending covenant with financial backers, it trades at a penny.

Even before New Century began its descent, we bought the January 2008 25 puts LEAPS, which then traded at $3.50. And as the stock fell even further, we bought 7.50 put LEAPS with big quick gains of 103% and 202% as the underlying stock fell quicker than expected.

Had we known that the stock would have dropped as it did, we would have bought nearer term put options. But we didnt. We wanted leverage for the long-term, and we didnt want the time decay hassle.

If we had shorted New Century from $30 to $5, for example, the max gain would be 83%. Buying the LEAPS gave us two triple digit gains.

You see, your total percentage gain is greater when buying a LEAPS call than what you’d see from an underlying stock.

Heres another example.

Say you’re anticipating an advance in the price of a stock over the next two years. You can opt for LEAPS to limit time decay exposure.

Stock ABC, as of December 2007, is trading at $60 a share, and a two-year LEAPS call with a strike price of $60 is trading at $5. You could buy five of these LEAPS call contracts for $2,500, (initial cost ($5) x # of shares in an options contract (100 x 5 contracts equals $2,500).

These five calls now give you the right to buy 500 shares of ABC between now and expiration at $60, no matter how high the stock rises. Your break-even point would be $65, or the strike price plus the premium paid.

Now, say your LEAPS, with a strike price of $60, soars to $75 by expiration. You have two options: You can exercise the five call contracts and own the stock by paying $60 a share, or you can exit the LEAPS position for a gain. If at the time of expiration, the stock traded at $75, you’d have a gain of about $7,500 (five contracts multiplied by 100 total of your cost per contract, multiplied by the price increase of, in this case, 15).

Now, remove the premium you paid ($5) and multiply that by the number of contracts (again multiplied by 100, which gives you your contract price), which comes out to $2,500.

After removing the premium paid, your total profit would be $5,000, or about 200%. Had you bought the underlying stock at $60 and rode it to $75, you’d only have a gain of about 25%.

Confused? Please dont be. Its very easy once you get the hang of it. Heres the profit difference when you exit the LEAPS call, as compared to exiting the stock.

Exit 5 LEAPS ABC 5 Call

Initial Cost ($5) x # of shares in contract (100) = $500

Cost ($5) x # of shares in contract (100) x exit price ($15) = $7,500

Profit before commission and removing premium = $7,500

Exit 500 shares of ABC at $60

Initial Cost = $30,000

If the stock rises to $75, you’re profit is $7,500 (does not include commission).

LEAPS Investing: Advantageous leverage

LEAPS strategies have many advantages as compared to just buying or short selling a stock.

First, the option premium is typically less that the amount of cash needed to buy a stock.

Second, since the maximum risk on a LEAP play is equal to the premium paid, you know exactly how much you could use. There’s limited risk.

Third, there’s unlimited reward. Hit breakeven (strike price + premium = breakeven), and your potential reward is unlimited.

If you’re not a buy and hold kind of investor, why buy underlying stocks? And why bother dealing with time decay by buying nearer term options?

They’re far too volatile.

But what if you just removed the time premium from the equation and hold an option for up to three years at a time? That’s what you’re doing with LEAPS options.

LEAPS cost only a fraction of owning a stock. And they’ve been known to rocket higher as the underlying price moves. Say you own a $50 stock, and it goes up $5. Your gain is 10%. But say you own the January 50 calls, for example, at a $1 and the stock went up $5. You could now be sitting on a few hundred percent gains.

That’s how you maximize your potential gains. Not by worrying about time decay, or making scant gains from holding overpriced stocks.

More positives for owning LEAPS:

Your risk is known. You can buy LEAPS calls if you think a stock is rising. You can buy LEAPS puts if you think a stock is heading lower. There’s a lack of time decay. You can play ‘big picture trends, using commodities such as gold. Say the dollar gets weaker. Investors run to gold as a safe haven, and you own the XAU LEAPS that’ll leverage your gains when gold moves in your direction.

LEAPS Investing: Homework

If youre confused with LEAPS, dont be. Youre simply buying options dated further out.

Will I leave you to figure out LEAPS on your own when you have questions? Absolutely not Im always available to answer questions, and am more than happy to help.

Heres some homework to get you started on your way to profiting from LEAPS with a call.

Ive spoken about Cree here before. Ive heard that some of you bought options already and did quite well. But for those that havent bought yet, I offer you this.

Soon, you wont find 100-watt incandescent light bulbs any more. Along with the typewriter, its time has come for the trash heaps.

Yep, as part of the 822-page measure inked by the President, the 100-watt incandescent bulbs will be banned by 2012. All light bulbs must use 25% to 30% less energy than todays lights by 2012.

By doing so, the U.S. would reportedly cut light electricity use by 60% by 2020, and cut U.S. electric bills by up to $18 billion a year. Its news bullish enough to move Cree (CREE:NASADQ), an LED (light emitting diode) company.

This is an industry expected to exceed $1 billion by 2011, a 388% jump from the $205 million market value in 2005. You really cant go wrong with buying Cree on that potential.

Heck, even Royal Philips Electronics is aware of the potential. It just announced it was buying Genlyte for $2.7 billion as part of its LED-related company buying spree, serving as another blow to its competitor, General Electric, as it strengthens is energy-efficient lighting business.

Who knows, maybe itll put pressure on GE to buy a company like Cree. Would it be a shock if a company, wanting to guarantee a supply of LED, came forward and paid Cree what it is worth? No. Therell be plenty of demand, and possible tight supply, which will benefit Cree-like companies.

Our prediction as we near the 2012 deadline, Im expecting CREE to make a move to $35. But instead of risking funds on a nearer term month, Id opt to buy LEAPS to limit exposure to time decay. Knowing that I want as much exposure to the industrys expected 388% growth as I possibly can, Ill buy call options going out as far as they go.

With that in mind, Id recommend buying January 2010 30 calls (YFAAF) up to $8, as LED companies, like CREE, beginning to penetrate more of the market.

Ian L. Cooper

P.S. Investors are scared. And they should be.

The U.S. service sector, which accounts for about 90% of GDP plunged into contraction during January. The ISM non-manufacturing number dropped to 41 in January from a December read of 54. Its the lowest read since 2001.

The number was so bad that the ISM released the news at 9 a.m. ET, an hour ahead of schedule, in an effort to suppress any leaks to the broader market.

But as weve mentioned, the Fed will attempt to prop up the economy with further rate cut aggression, met with a Bush Administration stimulus plan. But theres no guarantee that will snap the economic melee either.

But relax. Everything will be fine. Theres always a bull market somewhere. And its time to hunt in those very bull markets. as scarce as they may be. Full report.

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