You a More Conservative Investor? Here’s a Great Strategy

by George Leong, B. Comm.

In my previous commentary, I talked about the concept of stock or market reversals and the need to be aware of several chart patterns that could arise.

Given the current strong rally in stocks, you should be careful about chasing stocks higher, as there is always the risk of a correction. Yet, at the same time, you do not want to miss out on any upside.

A strategy that you could employ in some situations is the use of LEAPS or Long Term Equity Anticipation Securities — call or put options characterized by a time to expiry of more than nine months up to three years from the time of purchase. Compared to shorter-term options, LEAPS have several distinct features: more expensive; less speculative; time is not a major factor; and lower-risk/lower-return. So, while shorter-term options are generally advised only for aggressive traders, LEAPS are generally more conservative, since the window of opportunity is longer. For the more conservative investors or option traders, LEAPS provide an excellent alternative to a “buy and hold” strategy, because of the leverage involved, as well as the management of risk.

LEAPS were first introduced over a decade ago, in October 1990, by the CBOE on a few selected stocks. Since then, they have grown exponentially to include also indices and currencies.

The correlation between LEAPS, the underlying stock, and the fact that it has a long shelf life makes it an increasingly attractive vehicle for the more conservative investor who may not want to play short-term options.

I will look at LEAPS call options in this editorial. LEAPS calls on stocks will move up (down) dollar-for-dollar with the underlying stock above the breakeven point.

As an investor, LEAPS could be used in many scenarios.

Let’s say you’re near-term neutral, but long-term bullish on stocks. Under this set of assumptions, buying options with a longer time frame may make some sense. It also makes sense if you’re short of funds. For instance, buying 100 shares is way more expensive than buying one LEAPS contract that represents 100 shares. LEAPS give you the power of leverage, which is at the core of options and why they are attractive.

LEAPS also offer manageable risk. You know what your monetary risk is. The maximum you can lose through a LEAPS strategy is the premium you pay for initiating the LEAPS trade. You cannot lose more. Buying the actual stock exposes you to more risk; you could lose the entire outlay, as the stock can in theory move towards zero. LEAPS really pay off in the case that a company is taken over or the stock surges on major news. Just calculate the percentage returns of LEAPS versus buying the stock and you’ll realize the excellent leveraged returns via options.

And similar to normal options, you can also write covered and naked LEAPS calls. The underlying mechanics are identical, with the exception of the extended expiration date. You will also realize that you can use LEAPS in many more complex strategies just like normal options, such as spreads and combinations. You are only confined by your trading creativity.

Whatever may be the case, you should take a look at LEAPS as a viable investment.