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The Advantages to Using LEAPS Rather Than Buying Stock

April 2004
Dr. Terry F. Allen
www.terrystips.com
 

 

The only realistic way to achieve above average investment returns is to increase the risk you are willing to take. Not everyone is comfortable with anything that smells of risk. Some people buy CD's and pretend they're happy with the 2% or so they make on this investment. They may sleep well, but are they really living? Other people, including me, believe that taking a little bit more risk is worth the effort. Truly extraordinary returns are possible if you do. I can't understand why more people won't make the effort to learn a strategy that requires a little more risk, a little work, but can generate 100% or more in gains every year.

Increasing returns (and risk) with margin loans.

The most common way to seek extraordinary returns by increasing risk is to buy stock on margin. You can buy 2 shares for every 1 share you could have bought without using margin. Your broker happily loans you as much money as you put up, and charges you a very low interest rate. If the stock goes up by $1, you gain $2 since you have twice as many shares. Higher risk, higher profit.

Let's look at the downside, however. Buying on margin is a double-edged sword. Every time the stock drops by a dollar, you lose $2 because you now have twice as many shares. Worse yet, if the stock falls a lot, you get a margin call, and you may be forced to sell the stock at the very time the price is really low, and you would rather be buying it instead. Buying on margin is a dangerous strategy, and I would not recommend it as a general policy.

Gaining Leverage With Options.

Another common way to try to score superior investment returns is to buy stock options. Many people buy short-term calls (since they are the cheapest), and hope the stock skyrockets quickly. If they are right, they may make several hundred percent on their investment.

If they are wrong, which unfortunately is the case the great majority of the time, they lose everything. Every cent! What kind of an investment is this? It certainly doesn't interest me.

Of course, buying lottery tickets doesn't interest me, either. Nor do I get a kick out of the slot machines in Las Vegas. I like to think I am an investor, not a gambler. I don't like to play any games where the odds clearly favor the house.

Yet, every day, millions of people drop many more millions of coins in slot machines. Others spend mega-millions on lottery tickets. And I'm sure that thousands of people buy short-term calls. In my mind, they are all playing a losing game - for most of them, their only payoff is the brief fleeting psychic hope that they just might hit it big! I don't buy lottery tickets, play the slot machines, or "invest" in short term options. I prefer real profits to fleeting fantasies.

Increasing investment returns with LEAPS.

LEAPS are stock options that have an extended life. Many of them last for more than 2 years. Unlike short-term options, your stock does not have to skyrocket right away to make money. You have plenty of time for an upswing. If you follow the strategies that I use in my account, you can even make money if the stock never goes up at all.

LEAPS are available for almost 500 companies. You can get a complete list for free at http://www.cboe.com.

Just like stock options, LEAPS can be either puts or calls. I will focus on calls, as my favorite strategies assume either flat or rising markets (the market, on average, has gone up about 10% every year for over 50 years, in spite of our experience the last 3 years).

When you purchase a call LEAP, you gain much more leverage than buying on margin. Instead of putting up 50%, you may put up about 25% when you buy an at-the-market LEAP which expires in two years. Owning this LEAP gives you all the rights of ownership of 100 shares of the company's stock, except voting and getting dividends.

Why I prefer buying LEAPS to buying stock?

1) You get more bang for your buck. For the same amount of money, you can get twice as many shares as buying on margin, and 4 times as many shares as merely buying the stock.

2) You NEVER get a margin call. You get leverage without the worry of having to close out your position at the worst possible time.

3) In some important ways, owning a LEAP is less risky than owning the stock. Let's compare buying 100 shares of QQQ (the Nasdaq 100 tracing stock) for $27 x 100 = $2700 with buying a QQQ 27 call LEAP with 2 years remaining for $600 (This LEAP gives you the right, but not the obligation, to buy 100 shares of QQQ at $27 for 2 years.) If the stock falls $3 per share, you would lose $300 on your stock investment, but your LEAP would only fall by $120. If the stock falls another $3 per share, your stock investment would lose you another $300, while your LEAP would only fall by $70 in value.

The amount that the LEAP changes in price when the stock falls is based on a measure called the Delta value. (I will discuss delta values in a future report).

The Downside To Owning LEAPS.

Of course, there is one major disadvantage to owning LEAPS. If the price of the stock remains flat, the LEAP declines in value every single month. You own a depreciating asset, just like a car. (The amount that the LEAP falls in value each month is called the decay). Think of it as depreciation.

Most everyone owns a car or two, and we generally don't think much about the fact that our vehicles are getting worth less each month. The principle of owning a depreciating asset should be familiar to most of us. There are many option strategies available to offset this depreciation, such as selling short-term calls against the LEAPS.

An Analogy.

Let's use an analogy to explain how you can use a LEAP. Think of buying 10 LEAP call contracts as being equivalent to having a 2-year lease on a ten-room house. You pay $6000 up front for a two-year term. (You calculate that this works out to $250 total per month, or $25 per month per room for the entire 2 years.)

Further suppose that an important feature of your rental agreement is that you get to keep any appreciation in the house value over the two-year lease. If the house appreciates more than the $6000 you paid for the lease, you earn a profit. Another neat thing about your arrangement is that if the value of the house falls, you do not have to rebate anything to anyone for the lessened value.

You are also able to sublet rooms in your house. You learn that you can rent each of these rooms for $100 per month. That works out to be 4 times the $25 cost per room that you will be paying on the 2-year lease.

There is a catch, however. An appraiser comes along at the end of each month, and sets a new value on the house. This value determines how much rent you can charge for the next month. If the house value has fallen, you will not be able to charge $100 for the second month. Of course, if the house appreciates in value, the rental rate will increase as well.

There is another, more important catch, however. At the end of each month, you have to make a settlement with your tenants. If the house appreciated during the month, you must pay your tenants for their share of the appreciation.

While you may lose money on some rooms when you settle up at the end of the month, in the long run you really don't lose. When you suffer the loss on those rooms for that month, it was because the entire house went up in value. That is just what you were hoping for when you purchased the 2-year lease. Your rooms will command a higher rental in future months, and you ultimately gain from the appreciation of the entire house. It is only in the short-run that you seem to have lost money when the house went up in value.

Earning profits with your house lease.

There are two basic strategies for making money with your house. First, you could rent out only 3 rooms, collect $300, and make a small profit over the $250 pro-rata cost of your 2-year rental). With this strategy, you rent as few rooms as possible, just enough to get back your $250 monthly cost.

This strategy allows you to enjoy the benefits of LEAPS, (limited risk and lower capital requirements) while avoiding the only disadvantage (the decay cost). With this strategy, just as it is with owning stock, your real profit comes when your property appreciates in value.

You surely chose to lease a house that you expected to appreciate in value. Sometimes, the market is bound to disappoint you. If your house, indeed, goes down in value, you get to keep all the rent you got for the first month, but the rental value for the next month would fall. In this case, you might have to rent out 4 or 5 rooms to get back the $250 pro-rata monthly cost on your original investment.

The second strategy is to rent out more rooms than just enough to get back the $250 per month. If you rented 7 rooms, you would collect $700 rent for a single month. If you were able to do this for the entire 24-month period of your long-term lease, you would collect $16,800. You would have a profit of $10,800, or 155% on your original investment.

You probably are wondering why you wouldn't rent out all 10 rooms, and collect $1000 every month instead of $700. At this point, you will have to take my word for it. You can't rent all 10 rooms and make a profit most of the time. It would work if you knew the house valuation would stay the same, or increase or decline just a bit. But if the house value went way up, you would actually lose money if you rented all ten rooms every month.

Now, Back to Those LEAPS.

This house-renting analogy has a direct correlation to owning LEAPS as an alternative to owning stock. Using the Nasdaq 100 tracking stock, QQQ, as an example, a two-year call LEAP with QQQ selling at $27 would cost about $600 per contract. A one-month call on QQQ goes for a little over $100.

If you buy 10 of those LEAPS, you can sell someone else the same rights you have every month for 24 months. The amount that you charge them (called the time premium, or decay) for a single month will be about 4 times greater than the decay you will experience on the LEAPS you own.

 

This disparity between the monthly decay in the LEAP you own and the short-term call you sell to someone else is the fundamental essence and reason for success of most of the option strategies that I propose.

The only difficult part is knowing how to protect yourself against major shifts in the price of the stock. That is where I come in to help. To implement my strategies, you need to know exactly how many short-term options to sell (in the above analogy, how many rooms to rent).

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our disclaimer.

 




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