A Good Way to Manage Risk

Do you speculate in stocks? If you do, you may want to manage your risk by buying call options to bet on the stock rather than buying the stock outright. Moreover, given the current near record levels in stocks, you may not want to take significant positions because of the uncertainties and the threat of downside weakness. Buying large positions exposes your capital to downside risk. To help minimize the risk and control the capital that you put at risk, you may want to consider Long Term Equity Anticipation Securities or LEAPS.

LEAPS are call or put options characterized by a time to expiry of more than nine months to three years from the time of purchase. The extended time period allows your strategy to play out. The only disadvantage is the larger premium that you need to pay for the LEAPS. Hence, the stock would have to rise or fall much more than shorter-term options in order to make money.

Versus holding the same amount of the actual stock, the risk is much less due to the leverage involved in LEAPS and options in general.

Let’s say you like the digital satellite business longer-term and are looking at either XM Satellite Radio Holdings, Inc. (NASDAQ/XMSR) or Sirius Satellite Radio, Inc. (NASDAQ/SIRI). Also assume you want to give yourself some time for your strategy to play out. In this case, LEAPS would make sense.

For instance, you can play 1,000 shares of XM Satellite for a fraction of the cost by using LEAPS.

Let’s say you are interested in 1,000 shares of XM Satellite. Trading at $13.44, the capital outlay would be $13,444, excluding commissions. But you can alternatively buy 10 contracts (each contract represents 100 shares) of the January 2009 XM Satellite $15 LEAPS for $3,400 ($340 a contract excluding commissions). For about 25% of the total capital required for the stock position, you can partake in the move of the same number of shares via the XM Satellite LEAPS.

The upside breakeven is $18.40 ($15 strike plus $3.40 premium). As long as XM Satellite breaks $18.40 by January 16, 2009, you will make money. On the other hand, if XM Satellite begins to sink, your capital risk is far less using LEAPS.

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.

The correlation between LEAPS and the underlying stock and the fact that it has a long shelf life makes it an increasingly attractive vehicle for the more conservative investor.

In general, LEAPS call (put) option on stocks will move up (down) dollar-for-dollar with the underlying stock above (below) the breakeven point.

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