LEAPS investing can be an effective portfolio strategy for investing in high-growth stocks while reducing your overall portfolio exposure by trading one type of risk for another.
We’ve written before on the idea of using a LEAPS investing strategy for longer-term speculative investments but the question today is: Can leaps investing be used as a substitute for buying the underlying stock?
The answer is, generally, yes, if you know what to be on the lookout for.
Why use LEAPS investing instead of just buying shares?
Position scaling – Investing in 100 shares of SPDR S&P 500 ETF (SPY) requires, at writing, a roughly $44,500 investment. You could, on the other hand, using LEAPS investing, purchase a contract representing the same number of shares at the same price with an expiration in June of next year for $2,800. If the S&P 500 returns 9%, the value of the ETF position will be $48,500 while the LEAPS position will have returned 40% ($4,000 value). However, if the S&P 500 were to return 20% over that same period, the ETF investor would enjoy 20% returns (position value of $53,400) while the LEAPS investor would have a 217% return, with an initial $2,800 investment being worth $8,900 on expiration.
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As a substitute for a stop-loss – In the prior scenario we considered LEAPS investing in a bull market, but what happens should the market head south? If you use (or are considering) stop-loss orders for downside protection, you can think about LEAPS in a similar way. In the prior example, an investor in SPY with a 10% stop-loss with a $44,500 position value would be stopped out after a loss of $4,450.
The LEAPS buyer, on the other hand, can lose only the initial $2,800 investment, regardless of the returns of the underlying asset. This can help you avoid being whipsawed by an investment that goes up and down over the life of the contract. If SPY falls below 400 and remains there for several months, the LEAPS contracts will decline in value, but you aren’t out of the position and will participate in a market rally should the underlying asset run above the strike price of the contract.
What are the novel risks of LEAPS investing?
Liquidity – As a derivative product, LEAPS investing offers less liquidity than the shares the contracts represent and will have a wider spread between the bid and the ask. Targeting strike prices with high open interest (contracts in the marketplace) can alleviate some of this risk (round number strike prices are typically more popular). Liquidity becomes less of a concern when contracts are trading in-the-money (when the strike price is below the underlying asset value) because there is intrinsic value in the contract and you always have the option of exercising your LEAPS to buy and then sell the shares you’ve received.
Tax implications – If you buy a stock and hold it for a year and a day, you’ll pay lower long-term rates on any capital gains from selling the stock. The same is true for the LEAPS contracts. However, if you decide to exercise the contract and purchase the shares at the strike price, that resets the clock on the new position, and you’ll need to wait another year for lower capital gains rates. This is one reason that most LEAPS contracts are closed out via trading instead of exercised.
Volatility – This is both a positive and a potential risk. As for your position’s volatility, as we discussed above when talking about using LEAPS instead of stop-losses, the LEAPS don’t really magnify market volatility risk to your portfolio (your max loss is the amount you paid for the contract, regardless of volatility). However, volatility has a big impact on the cost of your initial investment. In the SPY example, a nine-month contract near-the-money costs approximately 9% of the underlying investment that the contract represents.
If we were to look at more volatile LEAPS investing with, say, Tesla (TSLA), we would find a similarly situated contract (at- or near-the-money, expiring June of next year) costs upwards of 16% of the underlying investment. That’s called a volatility premium. You can either reduce that by paying more up front and going in-the-money (which trades time and volatility premium for intrinsic value), or you can look at it in terms of a stop-loss (investors in more volatile stocks may be comfortable taking a 16% loss before being stopped out of a high-growth position).
Shareholder rights – When LEAPS investing, you’re not a true shareholder. That means that you’ll not receive regular dividends or voting rights. In some instances, such as a stock spin-off or return-of-capital special dividends, contracts are adjusted to convey those to the LEAPS buyer. So if generating income off the investment through dividends is important to you, you may want to consider simply buying shares.
These are only a few considerations if you’re thinking of LEAPS investing instead of buying the underlying stock, and the right decision depends on both the investor and the investment. That being said, with the right planning, LEAPS can be a viable replacement for buying stock outright.
If you’re new to trading LEAPS or options, our guide to Options Trading can help you get started.
Have you used LEAPS as a speculative investment or a stock analog in the past?
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