The recent decline in the markets after reaching some record highs shows why it is important to have some kind of risk management system in place. This could be stop-loss orders or simply taking some of the profits on stocks that have made major moves.
Yet if you do not want to miss a potential sustained upward move in the market, but don’t want to be left vulnerable to selling, you may want to manage your risk by buying call options to bet on the stock rather than buying the stock outright. And 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.
In rising markets, 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, if you are long-term.
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 chipmaker Intel Corp. (NASDAQ/INTC), which recently reported an excellent quarter. You like the stock for the longer term but want to manage your risk. In this case, LEAPS would make sense.
For instance, you can play 100 shares of Intel for a fraction of the cost by using LEAPS. Let’s say you are interested in 100 shares of Intel. Trading at $26.64, the capital outlay would be $2,664, excluding commissions. But you can alternatively buy one contract (each contract represents 100 shares) of the in-the-money January 2010 Intel $25 LEAPS for $600.00.
For less than 25% of the total capital required for the stock position, you can partake in the move of the same number of shares via the Intel LEAPS.
The upside breakeven is $31.00 ($25.00 strike plus $6.00 premium). As long as Intel breaks $31 by January 15, 2010, you will make money. Intel has an average one-year price target of $30.48; hence, reaching $31.00 in just over two years should be realistic assuming the company continues to show advancement. On the other hand, if Intel 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.