You can strategically use long-term option contracts to significantly increase your upside
potential while dramatically reducing your downside risk - like taking a stock that would
have a 1 down to 1 up risk/reward profile - and by using these contracts, making it
1 down to 5 up.
I’ll explain and I’ll show you how.
Coming up!
Hey there, my name is Stephen Spicer, and it’s my goal to help you invest smarter.
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Now, this video will be building on the detail and example packed video we just released
exploring the basics of options as well as how to profit from and when to use covered
calls.
If you missed that one, you really should start there - I’ll link to the playlist
in the description.
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Long-term call option contracts are actually technically called Long-term Equity AnticiPation
Securities, or LEAPS.
They really forced that acronym…
Since I’m assuming you’ve already seen the last video and now have a decent understanding
of how call options work, figuring out LEAPS is gonna be a sinch - even easier than covered
calls.
When we’re writing covered calls, we’re selling the option contract, and we do it
with only 30-45 days until expiration - since, as we talked about last time, that’s when
the time decay is increasingly working in the seller's favor!
With LEAPS, we’re doing the complete opposite.
We’re looking for contracts to BUY that have a year or more until expiration.
That’s it - it’s nothing super tricky - it’s not even some combination of stock
and option like we did last time or like we’ll do next time.
It’s just a plain vanilla call option with a really long time period until expiration.
Not every stock has them and this isn’t a strategy where you would go sifting through
available LEAPS to find a good deal - none of these strategies in this series are like
that.
You might use this strategy if - after you had identified a good value opportunity - you
then discover that LEAPS (on that underlying stock) are available to trade.
Then would be the right time to consider whether using LEAPS or using the underlying stock
itself would create the best risk/reward profile for your investment.
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Here’s the mindset where you might find LEAPS the more attractive option:
Your thesis (derived from your detailed research and analysis) suggests a significant upside
potential (say, 100%).
But the downside risk, even if you view it as less likely, is also significant (say,
100%).
The catalyst or two that you’ve identified that will cause the stock price to move one
way or the other will most likely occur within the next year or two.
Of course, you’re tempted by the massive upside potential.
But that downside risk, even if it is far less likely, doesn’t sit well with you.
LEAPS (if they exist for the stock in question) might be the perfect way to play it.
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You see, when you buy call options, the premium you’re paying is essentially made up of
two parts, 1.
Interest and 2.
protection.
The interest you’re essentially paying is on the dollar value of the stocks you control
with your contracts.
So, if your contracts expire in a month, the interest will be relatively small - you won’t
have the rights to those underlying shares for that long, so it stands to reason that
you’d pay much less.
However, if we’re talking about having those rights for (say) 24 months, it makes sense
that the premium would be quite a bit greater - you can think of this like interest you’re
paying for each additional month that you control the underlying asset.
And the second part you’re paying for is the protection.
If the stock price crashes, for example, the holder of the option contract isn’t exposed
to that - the person holding the underlying shares is.
You’re only risking this initial premium.
So, any amount above the interest you’re paying could be thought of as your downside
insurance premium.
So, in the loose example I gave earlier, by using LEAPS, you’d limit your downside risk
(to the premium you pay) while still being exposed to much of that significant upside
potential.
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Let’s get greater clarity by adding some numbers to this example:
XYZ stock is trading at $50 today.
There is a public concern of potential bankruptcy.
You conduct a thorough deep dive - like thorough - like what we walk through step-by-step in
my value investing course - and discover some solid evidence to suggest that the media has
it wrong - that within a year or two when the smoke clears, it’ll be obvious that
XYZ is solid and should be trading at a price that is at least double where it is today.
There are obviously some unknowables involved.
You could be wrong.
The company could actually be headed the way the media is portraying.
But you don’t think the chance of that is near as high as its price and trend would
suggest.
As Joel Greenblatt says in his book You Can Be A Stock Market Genius:
“Of course, I never invest in situations with complete certainty, anyway.
Situations that make sense and offer attractive returns given the risks involved - that’s
all I can really ask for.”
So, there is risk, but if your research-based thesis is correct, the price could easily
double - the upside potential of just straight up holding XYZ shares is 100%, but there is
also a nagging case for a 100% downside as well…
So you could weigh your conviction against that risk/reward profile to determine if buying
XYZ stock makes sense.
OR, you could check to see if there are LEAPS available.
Let’s say you find a LEAPS contract with an expiration that is 2 years from today with
a $50 strike price.
Its premium is (say) $10.
Now let’s play through the scenarios:
The catalysts that you had identified that would cause the stock price to either crash
or surge happen at some point in those two years.
If the price surges to $100, as you expected, you could exercise your option and immediately
net $40 per share on the entire trade - because you could buy the underlying shares for $50
and then immediately sell them for $100.
And then when you subtract out your initial investment of $10 per share, you realized
a 400% gain on the money you had exposed!
If, on the other hand, the underlying stock crashes, you’re out $10.
Whereas, if you’d had the stock, you’d be out $50 per share.
Pretty cool, right?
Similar upside potential with WAY less downside risk - and those of you who have been with
me for a while now know that combination is music to my ears.
One more quick example to help...
You could think of it like this: Using the setup from earlier, what if I offered to give
you a loan today to buy shares in XYZ.
I tell you that, of course, I’m going to charge you interest - I’m gonna ask for
it all up front - and it’ll be a little higher than you might see on other loans - not
as high as a credit card though.
Part of the reason the interest will be a little elevated, is because of the extremely
attractive bonus feature of this unique loan.
Specifically, if things don’t play out as you’re expecting, you don’t need to refund
me the principle - you don’t need to pay me back.
Can you imagine a loan like that for anything?
A business or investment opportunity - whatever.
It’d be crazy, right?!
But if you thought there was a relatively high probability of your business or investment
succeeding, well, you’d be crazy to not take those ridiculously advantageous loan
terms.
Well, the dynamics of LEAPS - although not technically a loan - they’re essentially
setting up for you this uniquely advantageous deal structure.
You pay the one premium on the front end for the right to profit from the trade if all
goes according to plan, according to your thesis.
But that’s it.
If things go south, you’re not on the hook for any thing else.
You see how you’re able to pay a relatively small premium in order to leverage control
of a much larger asset!?
Now, I’d only recommend this strategy when the psychology of the trade is as I described
- where the issues should be resolved within the allotted time period (1 to 2 years), where
there is significant upside potential, and (although not an essential criteria) it makes
even more sense when on top of all that the downside risk from owning stock outright might
be a little bit more than you’re willing to take.
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One final additional benefit to this is the way LEAPS are taxed.
That is, if you hold it for more than a year, any gains you realize will be taxed as long-term
capital gains.
This is, obviously, unique for an option contract as they are usually a pretty short term vehicle.
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Again, I hope your investment wheels are turning and you can see the benefit of learning more
and mastering these strategies.
Don’t forget to subscribe so you don’t miss the next one!
Until then, I’m here to help.
I wish you all the best.
Take care!