A Longer-term, Less Risky Profit Strategy

“Calling the Trend” Column, by George Leong, B.Comm.

One of the most significant advantages of employing options is the use of leverage; that is, you can increase your exposure to stocks with less initial upfront capital required.

Say you’re short-term neutral but long-term bullish on stocks — then buying options with a longer time frame may make some sense. It also makes sense if you’re short of funds and don’t want to miss out on a potential market reversal.

Whatever may be the case, take a look at Long Term Equity Anticipation Securities (LEAPS) — longer-term options that expire later than traditional options. The timeframes on LEAPS run from a minimum of nine months to a maximum of three years from the purchase date. LEAPS can be either calls or puts, depending on your investment outlook.

So what’s the big deal with LEAPS? If you’re at all familiar with options, you’d immediately realize that the erosion of time on the option is the option trader’s nemesis, unlike that of holding the underlying stocks, where time is not as critical.

For investors, a longer expiry translates into more time for your option strategy to pan out. Moreover, theory suggests that the price of a long-term option erodes at a much slower rate than normal options, which, at the end, benefits the holder of the option.

Let’s examine the concept of leverage in more detail. Let’s assume you’re positive on the long-term outlook for the Cisco Systems, Inc. (NASDAQ/CSCO) and interested in buying 500 shares. Problem is you don’t have the necessary funds. To buy the stock, you’d need to come up with $12,265, based on a price of $24.53 a share. For the average investor, this is far too costly.

A solution would be to consider buying LEAPS. You could buy five out-of-the-money Cisco January 2012 $25 LEAPS for $390.00 a contract or $1,950 for the total position. This option strategy gives you a similar reward profile versus the person who buys the 500 shares, but at a much lower cost. Moreover, the downside risk is limited with the LEAPS, since it’s capped at the premium paid, which in this case would be $1,950. This limited risk tends to make holding options in volatile times a more conservative strategy than holding the stock, especially in tech.

The Cisco LEAPS in our example gives the investor the right to buy the shares at the $25.00 strike price at any time prior to the expiry date on January 20, 2012.

A disadvantage of the Cisco LEAPS is that the breakeven level does not occur until the stock reaches $28.90 ($25.00 strike price + $3.90 premium). The leverage, however, more than compensates for the higher breakeven, especially if you’re short on cash. Plus, you have two years for the strategy to pan out.

Now let’s assume that you were correct on your long-term outlook and the price of the Cisco shares increase to $35.00 by the expiry. In this case, the LEAPS strategy would yield pre-commission profits of $3,050 ($35.00 – $28.90 x 5 contracts x 100 shares) if you decide to take the profits instead of exercising the five contracts. Your return on the option play would equate to 156% on the original investment, versus 43% if you had purchased the 500 shares instead. This reflects the power of using leverage.

The availability of LEAPS is broad.

You can easily create a diversified stock portfolio by using LEAPS and at a fraction of the cost. And, should the market surge, your returns from the LEAPS strategy would be much greater than if you held the actual stock.

Please note that the examples used here were merely for illustration and were not meant to be a recommendation of actual strategy. Because options are inherently risky, we recommend speaking with an options specialist before considering a strategy.