When to Buy an Option Instead of the Stock
LEAPS Offer Smaller Investment Risk
LEAPS Calls and Puts
When I find a company whose stock is struggling, but I think the company can turn around, I buy options known as LEAPS instead of buying the stock.
Long-Term Equity Anticipation Securities (LEAPS) are option contracts with expiration dates that are longer than one year. These options are no different than shorter-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to the stock without a large investment.
Let’s take a look at an instance in which we might implement such a strategy.
J.C. Penny’s (JCP) stock has been an all-out disaster over the last couple of years as the company has been seriously mismanaged. In fact, there are concerns about the company’s long-term sustainability.
I would not advocate buying the stock, however, if I would like to take a “speculative” trade on a potential bounce or company turnaround, I might buy some JCP LEAPS.
Bill Ackman of Pershing Square Capital Management recently sold his very large stake in the company—and took a beating on the stock—shortly after his appointed CEO Ron Johnson was fired.
More recently, however, it was announced that famed hedge fund titan George Soros and his fund, Soros Fund Management, had taken a 9% stake in the company.
If I wanted to put on a speculative trade that Ackman’s selling of his position may have been the low for the stock, and that Soros and other hedge funds who have been buying are going to push the company in the right direction, I could buy JCP January 15 Calls (expiring 1/17/2015) for $3.
With JCP trading yesterday at $13.50, 1,000 shares would cost $13,500. However, 10 of the LEAPS I mentioned above would cost just $3,000.
So if the company goes out of business, or the stock continues to slide, our JCP LEAP Call exposure is dramatically less than the exposure we’d have with an outright purchase of the stock.
This is the profit and loss graph illustrating where the JCP LEAP Call position could be on January 17, 2015:
As you can see, if JCP were to turnaround, we would participate in the stock’s rally, with significantly less risk than an outright purchase of the stock.
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Another way to use LEAPS is for a bearish trade.
Let’s say for example that you are bearish on Microsoft. You might think to yourself, “It’s a solid company but they aren’t innovating anymore. They’re too late to smartphones, too late to tablets and just not ahead of the curve anymore.” In such a scenario, you might use LEAP Puts to get bearish exposure to this stock.
With the stock trading at $33 you could theoretically buy 10 MSFT January 32 Puts (expiring 1/17/2015) for $5—a capital outlay of $5,000.
On the other hand, if you wanted to go out and short 1,000 shares of MSFT stock, you would likely pay substantial margin as the stock could theoretically go to infinity.
This is the profit and loss graph of where the Microsoft LEAP Put position could be on January 17, 2015:
As these examples show, you can use LEAP options to get long-term bullish and bearish market exposure with substantially less capital at risk.
Your guide to successful options trading,
Expert Analyst, Cabot Options Trader