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When to Buy an Option Instead of the Stock

When I find a company whose stock is struggling, I buy options known as LEAPS instead of buying the stock.

different-investment-options

If there’s a stock that’s looking particularly bad, you can always buy an option instead and use LEAPs to cash in.

When I find a company whose stock is struggling, but I think the company can turn around, this is when I would buy an option known as LEAPS instead of buying the stock.

Long-Term Equity Anticipation Securities (LEAPS) are option contracts with expiration dates that are longer than one year. These options are no different than shorter-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to the stock without a large investment.

Let’s take a look at an instance in which we might buy an option and implement such a strategy.

J.C. Penny’s (JCP) stock has been an all-out disaster over the last couple of years as the company has been seriously mismanaged. In fact, there are concerns about the company’s long-term sustainability.

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I would not advocate buying the stock, however, if I would like to take a “speculative” trade on a potential bounce or company turnaround, I might buy an option instead and buy some JCP LEAPS.

Bill Ackman of Pershing Square Capital Management recently sold his very large stake in the company—and took a beating on the stock—shortly after his appointed CEO Ron Johnson was fired.

More recently, however, it was announced that famed hedge fund titan George Soros and his fund, Soros Fund Management, had taken a 9% stake in the company.

If I wanted to put on a speculative trade that Ackman’s selling of his position may have been the low for the stock, and that Soros and other hedge funds who have been buying are going to push the company in the right direction, I could buy JCP January 15 Calls (expiring 1/17/2015) for $3.

With JCP trading at that time in 2013 at $13.50, 1,000 shares would cost $13,500. However, 10 of the LEAPS I mentioned above would cost just $3,000.

So if the company goes out of business, or the stock continues to slide, our JCP LEAP Call exposure is dramatically less than the exposure we’d have with an outright purchase of the stock.

If JCP were to turnaround, we would participate in the stock’s rally, with significantly less risk than an outright purchase of the stock.

Another way to buy an option and use LEAPS is for a bearish trade.

Let’s say for example that you are bearish on Microsoft. You might think to yourself, “It’s a solid company but they aren’t innovating anymore. They’re too late to smartphones, too late to tablets and just not ahead of the curve anymore.” In such a scenario, you might use LEAP Puts to get bearish exposure to this stock.

With the stock trading at $33 you could theoretically buy 10 MSFT January 32 Puts (expiring 1/17/2015) for $5—a capital outlay of $5,000.

On the other hand, if you wanted to go out and short 1,000 shares of MSFT stock, you would likely pay substantial margin as the stock could theoretically go to infinity.

You can use LEAP options to get long-term bullish and bearish market exposure with substantially less capital at risk.

Now it’s your turn, when have you decided to buy options instead of stocks? I’d love to hear it.

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*This article was first published in September 19, 2013.

Jacob Mintz is a professional options trader and editor of Cabot Options Trader. Using his proprietary options scans, Jacob creates and manages positions in equities based on unusual option activity and risk/reward.