The Smart Profits Report: Issue #483
Friday, December 21, 2007 LEAP Options: The Pro Strategy That Provides Protection And 177% Profits
By Karim Rahemtulla
Investment Director, Mt. Vernon Research The stock market historically performs pretty well in the runup to the holidays - giving investors the so-called "Santa Claus Rally" that you may have heard the financial media yapping about recently. The pundits ask each other whether we'll get one… but none of them seem to have much idea. They just excitedly blurt out "yes," but don't actually back it up with any firm evidence. One thing is certain, however: Santa Claus is nowhere to be found this year and the market is not cooperating with investors. In fact, rather than enter the holidays in good spirits, it's being rather stingy. We've laid out several reasons for the downturn in this column over the past few weeks and given you tips on how to handle it - direct from our team of pros. Today, I'm going to give you another professional way to stay invested, even when others are bailing out, by using LEAP options - a tactic that gives you three great benefits: Time, Protection, and Profits. When the stock market takes a turn for the worse, most investors hitch up the wagon and pile out of Dodge as fast as they can (with the immortal words of the so-called TV experts ringing in their ears as they go). But I've got another solution: Stay invested and preserve your capital. Sounds like an oxymoron, right? It's not. For almost a decade now, I've beaten the drum for one particular investment strategy that is basically a proxy for owning stocks. It's powerful. It's protective. And above all, it's profitable. Welcome to the world of LEAP options… LEAP Options - Powerful, Protective And Profitable Most people still consider options a short-term, speculative tool that is way too risky. Don't fall for the stereotype - this could not be farther from the truth. LEAP options are long-term options that expire in one, two, even three years from date of issue. And they give you benefits that most regular stockholders don't get: - You get to own a stock at a discount price.
- You get all the upside - even more on a percentage basis.
- You have much less capital at risk.
So how does this work in reality? Glad you asked… Let's apply those benefits to the current mess in the financial sector. And I'll start by going on record: The mess will pass. And if you're brave enough to invest when "blood is running on Wall Street," you'll be amply rewarded in a year or two - just enough time to adopt a LEAP option strategy. Here's how it could work… You've Got Two Choices: 51% Or 177%? Consider a portfolio of five beaten-down financials (you don't have to look very far to find them these days!) According to my calculations if you were to simply buy 1,000 shares of each, your outlay would be about $225,000, based on current prices. That's a lot of dough. So before I go any further, let's make a few assumptions: - You don't have $225,000 to spend on 5,000 financial sector shares.
- Each stock will revisit its 2007 high price before January 2010.
- You employ a 20% stop-loss from current levels.
But here's how that scenario would work if you ditch the straight stock approach and go for LEAP options instead… - You Significantly Reduce Your Cost From The Start: A portfolio of at-the-money LEAP options (those whose strike price is closest to the current price of the underlying shares) would cost you about 20% of the amount invested if you wanted to control 1,000 shares of each company. In total, about $45,000.
- You Turn A Great Profit: If you just invested in the stocks outright, the portfolio would be worth about $340,000 at the 2007 highs - a fat profit of $115,000 (51%).
Using A LEAP Options Proxy Portfolio But using a LEAP options proxy portfolio, the gain would be about $80,000, turning that $45,000 investment into $125,000 - a 177% net profit ($125,000 minus $45,000), but with only $45,000 at risk. And if you employed a 20% stop-loss on your stock portfolio, the loss on your investment when you actually bought the shares would be more than the actual funds you had at risk for your entire LEAP portfolio. With the LEAP options portfolio, the most cash you have at risk in a worst-case scenario is still limited to the initial $45,000. But what if the financial sector recovery were to occur quicker than expected? In this case, your gains could actually be much higher, thanks to the value of money and the amount of time left until expiration. Even better, my assumption is based on you cashing out at options expiration, not before. But in most cases, the cash-out would occur long before expiration by selling the very same LEAP options that you purchased. And you'll walk away with gains that simple stock investors can only dream about. Karim Rahemtulla Today's Smart Profits Action Center - That's the theory, but how about the practice - and the real profits? You got it. How about 133% on Tenet Healthcare January 2010 $5 calls? Or 93% on a bull spread trade on Freeport January 2009 $60 calls and $70 calls? (Read more about this trade in Smart Profits #467, Spread Trading: Lower Your Cost And Hedge Your Risk In One Profitable Bull Spread Trade).
These are just a couple of the real-life profits that my LEAPS Trader members have pocketed this year. Find out how you can join them by giving our friendly VIP Trading Services folks a call - they'll tell you everything you need to know about how to buy quality companies for very low prices and profit from very small moves in the underlying stocks. Make money in the long run with LEAPS Trader. Call 888.570.9830 (inside the U.S.), or 410.454.0498 (from overseas).
- The common denominator with all options strategies is leverage. It's clear that many of our subscribers are either unaware of this concept completely, or don't understand how to incorporate it into their investment strategy. Simply put, options offer this leverage investment. After all, if you can control 1,000 shares of a stock for a dollar a share, why pay $50 a share? The problem is trying to figure out which strategy is right for you. Find out more in Smart Profits #382, Leverage Investments: How To Use Options Delta To Vanquish Volatility.
- For all the options terminology definitions you need like "LEAPS" and "bull spread" mentioned above - check out our Smart Profits Glossary.
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