LEAPS are long-term options on stocks. The word LEAPS is an acronym that stands for Long Term Equity AnticiPation Security. This sounds really complicated but it isn’t. With LEAPS and other options, you pay a premium for the right to buy shares at a fixed price for a certain time.
You might pay $10 for the right to buy one share of XYZ stock at $100 per share up until the options expire. You have that right no matter how high the stock price goes. So if the stock goes up to $150 within the time-frame, you make out like a bandit.
You paid $10 to buy a share at $100 (for a total cost of $110 per share) and you can sell that share for $150. That’s a sweet profit of $40. If you bought 100 LEAPS, your profit would be $4000 on an investment of only $1000. That’s a tidy and tingly profit of 400% and enough to make you feel like a financial genius. Win-Win.
Why LEAPS Are Not A Good Fit For Most Investors
Despite the attractive scenario I painted above, you should probably stay clear of these contraptions. Remember I said that when you buy LEAPS you have rights that expire over time? Well I wasn’t kidding. Look at the example above. Let’s say you bought the LEAPS in question in January and they expire on August 1st. If the price of XYZ stays at $100 or below until August 1st, the value of those rights will be 0 on August 2nd. If that’s the case, it means you’ll lose 100% of your money. Enough to ruin anyone’s barbeque.
And you don’t even have to wait until the very end of the expiration period to lose a lot of money. As you get closer and closer to the expiration date, the value of the LEAPS drop dramatically.
The greater the volatility of the stock in question the greater the premium too. A client asked me to look into TESLA options so I did. As of 8/22/14 the stock price of TESLA was $256.78 per share. If my client wants to buy TESLA LEAPS he’ll pay $50.70 for every right to buy the shares at $250 per share. That means the stock will have to rise above $300 before he breaks even. Oh, and the stock will have to do so before January 15, 2016. If it doesn’t, he’ll lose money on the deal because on January 16th his rights expire and become worthless.
I don’t know if TESLA is a good stock to buy or not. I am not recommending you buy or sell shares. I am simply using this stock as a way to illustrate how LEAPS work. If you’d like to talk about the best investments for you, please drop me a line.
The Benefits Of Leaps
As you saw by way of the first example, if the stock rises above the exercise price PLUS the premium, you can make a killing. LEAPS provide a great deal of leverage. That means you don’t have to put up very much in order to capture the potential for a great deal of profit. Again, in our first example, the investor snagged a profit of $4000 on a $1000 investment.
And if we go back to our TESLA example, the investor doesn’t have to wait until January 15th 2016 in order to cash in. Let’s say the price of the stock goes up to $320 by November 2015. He can sell the LEAPS and profit at least $20 per share and that works out to a 40% profit. Remember, he paid $50 to buy shares at $250. She exercises that right so her cost all in is then $300 per share. If he sells the shares and receives $320 per share, her profit is $20 on every $50 she invested and that my Pilgrim friend is a delicious 40%.
I am no fan of LEAPS for investors. In order to make money you must time the market perfectly. If you are a long-term investor why take on the extra risk? It’s hard enough to make the right decision when it comes to individual stocks. If you have to buy the right stocks at exactly at the right time, that makes it all that much more difficult.
If you believe in a stock and it’s the right fit for you, why not just buy the stock outright? Better yet, why not reduce the risk by buying funds and ETFs instead?
Have you had any experience buying or selling LEAPS? If so, what was your experience?