Investors looking to beat the market may want to consider trading LEAPS options to add a little leverage to their position without taking on too much risk. The term LEAPS is actually an acronym for Long-term Equity Anticipation Securities, which are options that have expiration dates one to two years in the future. (Most regular options are traded with expirations within 9 months or less).
The extra time value on LEAPS allows your option trade to be less expensive over time in terms of premium than shorter dated options. For example, if you purchase the SPY February 2012 $130 strike call for $4.72, the cost in premium would amount to $157 per month. However, if you purchase a LEAP such as the January 2013 $130 strike call for $9.95, your premium would be only $71 per month.
Purchasing LEAPS is also less expensive than purchasing 100 shares of the underlying stock. 100 shares of SPY would currently cost $12,667, but one January 2013 call would only cost $995. Keep in mind that if the underlying stock was purchased, you could hold onto it forever, but the LEAPS options would expire in January 2013. Therefore, investors need to weigh the advantages and disadvantages based on where they think the market is heading. If you feel confident that the market will rise steadily over the next year and you’re willing to lose the $995 if the call option doesn’t end up in the money, then trading the LEAPS may be your best bet.
Another advantage to purchasing the LEAPS is less exposure to total risk. Let’s say the market takes a 20% tumble over the next year. If the LEAPS were purchased, you would lose a total of $995 for the call that was purchased. However, if 100 shares of SPY were purchased, then the total loss would be $2533 or 2.55 times more than if the LEAPS were purchased. On the other hand, if the underlying SPY shares were purchased, you could continue to hold onto them until the market recovers - but you would have a lot more money tied up with owning the underlying shares.
Another primary advantage for purchasing LEAPS is the extra leverage, or higher potential for larger percentage gains. This is how you can beat the market with the market so to speak, by trading SPY. Since SPY is a representation of the stocks in the S&P 500, the higher percentage gains with LEAPS can allow investors to beat the market significantly.
Let’s compare the possible gains with both scenarios. Let’s say the market has a 10% gain from now until January 2013 (assuming that the world doesn’t end in December 2012). This means that if we bought 100 shares of the underlying SPY stock, we would have a 10% gain plus dividends of 1.96% for a total gain of 11.96%. With the LEAPS January 2013 $130 strike call, we’ll estimate a delta of 0.5. The 0.5 delta represents the movement in the option price in relation to the movement in the underlying stock price. So, in this example, a $1 rise in the price of the underlying stock would result in a 50 cent rise in the option price.
On a percentage basis, the $1 rise in stock would only amount to a 0.79% rise in the underlying stock position, but the LEAPS call option would rise 5% (5 times higher than the stock). If the stock rose to around $139 by January 2013, we could estimate that the LEAPS call option would rise $617 (from $995 to $1612) – a 62% increase! That’s over 400% higher than the market’s return. Here you can see how LEAPS can help you blow away the returns of the market.
The returns from LEAPS can also be further accelerated by selling a call option against the LEAPS call option that was bought. Consider selling an out of the money call every month to really accelerate your gains. Let’s say you sold a $1 call option every month for a year while holding the bought LEAPS call option. Assuming the sold options expired every month -- that’s a $100 gain every month or an extra $1200 for the year.
Keep in mind that the LEAPS will be more volatile than the underlying stock. Every $1 drop in the underlying stock will result in an approximate 50 cent drop in the LEAPS call option. Since one call option represents 100 shares of stock, a $1 drop in the underlying would result in an approximate loss of $50 for the LEAPS call option.
Keep in mind that if a LEAPS call option was purchased, the underlying stock would have to be above the strike price by the expiration date, otherwise it would expire worthless. The $130 strike price that we picked is only 2.6% higher than the current price of SPY. Therefore, the market needs to move only 2.6% by the January 2013 expiration date to squeak out a profit. If the market only moved by 2.6% in that time frame, you would still have a gain of about $167 or 16.7% with the LEAPS call option. However, if the price of SPY was $129.99 or lower at the time of expiration, you would lose the entire $995 price of the call option.
LEAPS may not be for everyone, but it is something that investors should consider as a part of their portfolio as a technique to beat the market over time. If you would like to learn more about options please visit 888options.com.
Disclosure: I am long SPY.