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Stock Option LEAPS
The Smart Profits Report: Issue #121
Thursday, June 24, 2004
Stock Option LEAPS: Buying LEAPS Or Stocks… What You Should Do
by Karim Rahemtulla
Investment Director, Mt. Vernon Research
Okay, I need you to be brutally honest. How long do you hold a stock, on average, after you buy it? Or sell it short?
I have been asking that question at all of my seminars, and the answer that I get is either a couple of months, or until a 20% or 30% gain is made. That answer is given by about 90% of the audience. And, who can blame them, after the last five years of corporate shenanigans… investment banking fraud… portfolio decimation… geopolitical problems… war… you name it?
So, here’s the deal. If you have a choice of buying stock option LEAPS vs. owning the stock, what should you do? My solution, and one that I have used very successfully is to buy LEAPS - Long-term Equity Anticipation Securities - instead of shares. These are long-term options. Here’s my thinking:
LEAPS vs. Stocks: Owning Almost Any Stock for Pennies
Say you want to buy 1,000 shares of Cisco because you think it is headed higher, from $22 a share. You can spend $22,000 and own the shares in the conventional way. Or, you can buy a Cisco stock option LEAPS.
First you have to think about the pros and cons and how you’ll handle the trade. Let’s say you are shooting for a 30% return on Cisco, and you are going to use a 20% stop loss. You’ll get out automatically if the shares drop 20% below your entry price.
And, to complete the picture, let’s say you are a reasonable person. You are going to give yourself one full year (or until your stop or target has been reached) for the shares to reach your target.
Here’s how that works out for the shares (dollar values are rough estimates):
- Cisco is at $22.
- Your target is $29.
- And your downside stop is at $17.60.
So you are looking to make $7,000 (and you’re willing to lose $4,400) on this trade.
Now, here is an alternative:
- You could buy a Cisco one-year LEAPS stock option.
- With a $22.50 strike price and pay about $2.50 per share.
Your total investment using the LEAPS option would be $2,500.
LEAPS $2K vs. Stocks $22k: Which Investment Is Better?
With the stock option LEAPS, you have invested $2,500 instead of $22,000 for the shares. However, your downside on the LEAPS is $2,500 versus $4,400 for the shares. Definitely a better deal with the LEAPS options if Cisco falls 20%.
Now let’s compare the upside. With the shares you stand to make $7,000, or 30%, if you hit your target. But you have to put $22,500 at risk to get it.
With the stock option LEAPS you stand to make $4,000 ($29 minus $22.50, minus the $2.50 cost for the option per share, since your 10 contracts control 1,000 shares.)
This amounts to a 160% return on your $2,500 cost for the LEAPS - more than five times the 30% you were seeking by owning the shares. And, the actual dollar return of $4,000, while lower than $7,000, is HUGE considering you only had $2,500 at risk instead of $22,000.
LEAPS Any Day Of The Week
In the current environment I advocate LEAPS stock options over owning shares, any day of the week. You can limit your downside, have unlimited upside, and have only 10% to 15% of your money at risk instead of 100%. If you use a sell-stop on your LEAPS, you can make that equation more favorable.
One more thing: In order to make money on your stock option LEAPS, the shares have to move very little. More on that to come…
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “LEAPS” or “call option” found in today’s article.
- For more on LEAPS, swing over to Smart Profits #275, Using LEAPS: These Options Are Set To Run Full Tilt.
Related Articles:
- Trailing Stops: How to Give Your Options Room to Grow
- Trading LEAPS: How to Get 1,100% Returns from Your IRA
- LEAP Options: The Intel Bargain & A Potential 566% Return
