A Way to Protect Yourself Against Downside Moves

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

Markets are showing an upward bias at this point, but there is concern that the rally will face increased selling pressure, as stocks edge higher. With the NASDAQ up over 70% from its March low, you would have to surmise that some profit-takers will emerge. The upcoming post-Thanksgiving shopping period will be critical for the economy, but without renewal in the jobs and housing market, it will not be easy and this exposes you to downside moves.

If you are nearly fully invested or have little capital to invest but want to play further upside potential, you may want to buy call options. What I like about options is the limited risk and leveraged returns that can be made if your trade pans out or fails.

You could manage your risk by buying call options to bet on the stock rather than buying the stock outright. Buying large positions exposes your capital to downside risk.

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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 Google Inc. (NASDAQ/GOOG, $571.00). You can play 100 shares of Google for a fraction of the cost by using LEAPS. Let’s say you are interested in 100 shares of Google. Trading at $571.00, the capital outlay would be $57,100, excluding commissions. But you can alternatively buy one contract (each contract represents 100 shares) of the in-the-money June 2010 Google $570 LEAPS for $51.30 ($5,130 a contract, excluding commissions).

For about 10% of the total capital required for the stock position, you can partake in the move of the same number of shares via the Google LEAPS.

The upside breakeven is $621.30 ($570.00 strike plus $51.30 premium). As long as Google breaks $621.30 by the June 18, 2010, expiry, you will make money. On the other hand, if Google 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, a 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, you can use LEAPS in many scenarios.