Options have become an integral part of the investing landscape and a plethora of option strategies have sprung up too, ranging from aggressive directional bets to protective hedges. One option strategy I like to use is to buy deep-in-the-money (DITM) call LEAPS in order to play a longer term directional bet on a stock, sector, or index.
LEAPS – Publicly traded options contracts with expiration dates that are longer than one year. Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts. The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. – www.investopedia.com
Options are attractive investment tools because of the large returns they offer. The reason they can produce such large returns is due to the imbedded leverage. An investor can buy 100 shares of stock or for a fraction of the price an investor can buy an option contract and still control 100 shares of the same stock. However, leverage is a double-edged sword, it can produce large gains but it can also cause large losses. It is because of the potential for large losses that I gravitate towards option strategies where my total risk is known but the potential for large rewards are still there. Buying DITM call LEAPs provide a known risk, the purchase price, with large potential rewards.
With a DITM call I’m trying to strike a balance between cheapness, ability of the option to participate in the underlying stock’s price movement and enough leverage to produce larger gains than the outright ownership of the underlying stock. I tend to find this balance with call LEAPS that have strike prices at a 50% discount to the underlying stock’s current trading price. By buying a DITM call LEAP at a 50% discount not only am I buying 100 shares 50% cheaper but is usually produces options with deltas above 0.9. For every $1 move in the underlying stock price my option should experience 90% of the price appreciation. Because I paid 50% less for the 100 shares and I’m getting an almost 1-for-1 price movement I’ve leveraged my potential returns. It is not a high level of leverage but it is enough to juice any positive returns experienced by the stock. Sometimes I will buy call LEAPs with deltas below 0.9 to generate larger returns but this is only when my conviction level in a position is high and I still won’t go below a delta of 0.8.
Another added benefit of buying DITM call LEAPs is the amount of intrinsic value that they already have. The value of options are based on two components, their time value and intrinsic value. The more “in-the-money” an option is the more intrinsic value the option has. This adds a little protection to my capital if my investment idea does not work out. If I no longer like the fundamental or technical outlook of the underlying stock I can sell the DITM call LEAP for its remaining intrinsic value. I will take a loss because of the erosion of its time value but hopefully I’ve changed my mind early enough to recoup a lot of the remaining intrinsic value.
I generally like to use this option strategy when the stock I’m interested in doesn’t pay a dividend or the dividend is so small that it will be negligible to my potential total returns. In these situations I am entirely dependent on capital gains and using a DITM call LEAP strategy should produce larger capital gains then just holding the underlying stock outright.
Example
Back on April 29, 2009 Visa, Inc (V) was trading at $63.60 and the $30 strike call options expiring January 21, 2011 we’re trading at an asking price of $35.70. Back then Visa (V) had a strong fundamental case, a strong techincal/trend case, and a lot of the Tiger Cub hedge funds were making Visa (V) and Mastercard (MA) their top holdings.
As of the close on April 20, 2010 The current bid price on these option contracts is $63.50 and Visa (V) is now trading at $94.05. Total return on the DITM LEAP Call Option = 77.87%. Return on Visa (V) less dividends = 47.88%. Visa (V) did payout $0.46 per share in dividends during this time and comissions were left out of both return calculations.
Further Reading
- If you don’t know anything about options I recommend starting with a book like “Getting Started in Options” by Michael C. Thomsett.
- Then once you have the basics you can learn more about the different option strategies through books like “Option Theory and Trading” by Ron Ianieri
- For more on using LEAPs as long-term directional plays read “Get Rich with Options” by Lee Lowell or “You Can Be a Stock Market Genius” by Joel Greenblatt.
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