LEAPS a Good Instrument for New Options Investors
Options investing is best left to more seasoned investors, but for those making the jump into such investments, LEAPs can be a very good choice.
Many inexperienced and newer investors hear the siren call of equity options, ignoring the advice of investment professionals and delving into buying and selling calls and puts without the requisite knowledge to truly understand and trade in them. While it is true that options can be risky investments, as long as the investor understands the risk and reward associated with these types of investments, trading in them is relatively safe. Options trading without a clear understanding, however, is a potential recipe for disaster.
With that standard disclaimer out of the way, we'll work under the assumption that you understand the basics of options. For those who are relatively new to investing, and who understand but are hesitant to begin trading options, there are investment instruments that offer a better choice. These are referred to as "LEAPS," which stands for "Long-Term Equity Anticipation Securities." In essence, these LEAPS are merely options that have expiration dates that are much further in the future. As such, novice investors can generally avoid the risk associated with very short-term expiration dates and utilize LEAPS to gain leverage without undue risk.
Equity LEAPS have expiration dates in January that extend out for two years, the result of which is a long, two-year window during which the underlying equity can move in the anticipated direction and make the investment a winner. As with any investment, of course, the price of the underlying stock can easily go in the opposite direction of the anticipated movement. For the savvy investor, however, LEAPS offer a limited-risk, big reward play that, utilized properly, can be highly effective. To illustrate this, we'll examine a hypothetical scenario.
Let's say that you're interested in the stock of "XYZ Corp.," which is trading at $10 per share. You've done the research and fully expect that the price of the stock could go up to $20 within the next two years. So, if you wanted to make a trade based on this assumption, you could buy 1,000 shares of the stock of XYZ for $10,000. Let's say, for instance, that the price then goes to $20 after two years. Closing the position (selling all the shares) would result in a gain of $10,000 - a gain of 100% in just 2 years!
Now, however, consider an alternative. LEAP options offer the buyer of calls to control 100 shares of the underlying stock for every contract purchased. If we assume that the $15 LEAP call option for XYZ Corp. that expires in two years is priced at $2, that means that each contract will cost $200 ($2 x 100 shares). What this means is that the same $10,000 would allow the investor to control 5,000 shares of XYZ Corp. ($10,000 divided by $200 equals 50 contracts, which controls 50 x 100 shares, or 5,000 total shares).
Finally, let's assume the same price jump for XYZ Corp. as in our initial investment scenario: $20 per share at the end of the two-year period. The investor using LEAPS to capitalize on this price movement will be able to exercise his shares at $20, so that his gain is the difference between the gross value of shares (5,000 x $20, or $100,000) less the exercise price plus option premium (5,000 x $17, or $85,000). The $17 figure is determined by adding the strike price of $15 to the $2 cost of the option premium. The net gain on the trade turns out to be $15,000 (150%) rather than the $10,000 gain associated with buying the underlying shares.
While this is merely a hypothetical trade used to determine the "value" that LEAP options present, it is a good indication of what LEAP options can do if utilized properly. For those ready to delve into investing that goes beyond buying stocks and selling of stocks, LEAP options can be a good choice.
With that standard disclaimer out of the way, we'll work under the assumption that you understand the basics of options. For those who are relatively new to investing, and who understand but are hesitant to begin trading options, there are investment instruments that offer a better choice. These are referred to as "LEAPS," which stands for "Long-Term Equity Anticipation Securities." In essence, these LEAPS are merely options that have expiration dates that are much further in the future. As such, novice investors can generally avoid the risk associated with very short-term expiration dates and utilize LEAPS to gain leverage without undue risk.
Equity LEAPS have expiration dates in January that extend out for two years, the result of which is a long, two-year window during which the underlying equity can move in the anticipated direction and make the investment a winner. As with any investment, of course, the price of the underlying stock can easily go in the opposite direction of the anticipated movement. For the savvy investor, however, LEAPS offer a limited-risk, big reward play that, utilized properly, can be highly effective. To illustrate this, we'll examine a hypothetical scenario.
Let's say that you're interested in the stock of "XYZ Corp.," which is trading at $10 per share. You've done the research and fully expect that the price of the stock could go up to $20 within the next two years. So, if you wanted to make a trade based on this assumption, you could buy 1,000 shares of the stock of XYZ for $10,000. Let's say, for instance, that the price then goes to $20 after two years. Closing the position (selling all the shares) would result in a gain of $10,000 - a gain of 100% in just 2 years!
Now, however, consider an alternative. LEAP options offer the buyer of calls to control 100 shares of the underlying stock for every contract purchased. If we assume that the $15 LEAP call option for XYZ Corp. that expires in two years is priced at $2, that means that each contract will cost $200 ($2 x 100 shares). What this means is that the same $10,000 would allow the investor to control 5,000 shares of XYZ Corp. ($10,000 divided by $200 equals 50 contracts, which controls 50 x 100 shares, or 5,000 total shares).
Finally, let's assume the same price jump for XYZ Corp. as in our initial investment scenario: $20 per share at the end of the two-year period. The investor using LEAPS to capitalize on this price movement will be able to exercise his shares at $20, so that his gain is the difference between the gross value of shares (5,000 x $20, or $100,000) less the exercise price plus option premium (5,000 x $17, or $85,000). The $17 figure is determined by adding the strike price of $15 to the $2 cost of the option premium. The net gain on the trade turns out to be $15,000 (150%) rather than the $10,000 gain associated with buying the underlying shares.
While this is merely a hypothetical trade used to determine the "value" that LEAP options present, it is a good indication of what LEAP options can do if utilized properly. For those ready to delve into investing that goes beyond buying stocks and selling of stocks, LEAP options can be a good choice.
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