Long-term options called LEAPS are a great way for an investor with a small account to profit from the long-term rise in the stock market. However, the option you use must be chosen carefully.
Long Term Equity AnticiPation Securities or LEAPS are available for two years in advance on 2,500 equities, ETFs and 20 indexes. The "S" is sometimes ignored in print. However, just because a LEAP is available on a stock does not make it a bargain.
LEAPS are regular call and put options but they expire only in January. That means you can buy a call or option that expires 12 or 24 months or more into the future. Because LEAPS are added to stocks during the year there are always a few extra months available. For instance in October you can buy a LEAP for January two years out and have 27 months until expiration.
Buying LEAPS two-years out is not really an everyday strategy. Can you really predict stock and market movement for two years in advance? Ideally, if the market were to crash like the 2008 Financial Crisis or the budget crisis in 2011 then buying two-year LEAPS on stocks that were severely crushed could be a good strategy. However, predicting market movement for even a year out is normally a challenge.
The best entry point for a LEAP may be during a market crash but that is not the only way to profit. Individual stocks crash much more often than the market. Companies miss earnings, make acquisitions or are affected by some change in their sector. Buying LEAPS on dips in individual companies is the normal method used by investors.
If you are fortunate enough to experience a severe market drop, then buying LEAPS on indexes is a slam dunk strategy. The market will normally rebound even if it takes weeks of months to recover. Investors can buy LEAPS on ETFs that follow indexes. For instance, the Russell 2000 ETF most commonly used is the IWM. The Nasdaq 100 big cap index ($NDX) has the QQQ ETF. The S&P-500 ETF is the SPY and the DIA is for the Dow Industrials.
A market drop is a prime example of buying when there is panic in the streets. Investors are dumping stocks left and right trying to save any existing profits or limit losses on existing positions. Stocks plummet and call option premiums implode. It is the perfect time to buy LEAPS on index ETFs.
Since major market drops come along maybe once or twice a year or sometimes even less there is a another strategy for individual stocks. We use the same principal of buying a depressed stock but instead of buying the dip, we try to buy the rebound. Indexes will not go to zero but stocks can and do go to near zero all the time. I would rather look for signs of a bottom and recovery before putting long-term money at risk.
I am going to use Franklin Resources (BEN) as an example. Franklin peaked at $59 in December of 2014 before it fell on hard times. I am not going into the details because they are not relative to this article.
The key point here is that BEN reported earnings in late October and the stock has begun to recover. The stock crashed for a year and is now recovering. Most stocks recover to their prior ranges after an event related decline. Franklin is $41 now and traded at $59 less than a year ago. While nobody can guarantee that Franklin will recover to the prior highs it is worth exploring.
The January 2017 $45 LEAP call is trading at $2.85 in early November. The January 2018 $45 call is $4.90.
If you bought the 2017 call your breakeven would be $47.85 with the potential for shares of BEN to return to the $59 level from last December or even higher. Obviously, you do not have to wait for January 2017 to sell your call and take a profit. If Ben were to continue sprinting higher to $50 over the next two months your call would double and you could exit with a profit or continue holding for all of 2016.
I would not use the 2018 call because the price is too high and the time too long. While it is possible BEN could rally to $100 over the next two years it is also more than likely the market is going to dip significantly 2-3 times over the next two years. That would deflate BEN and your LEAP premiums.
The key to profiting with LEAPS is to buy when stocks are depressed and recovering and long-term option prices are low.
It is also not a good idea to buy LEAPS on expensive momentum stocks and especially not when they are making new highs. For instance, Facebook (FB) reported earnings in early November and shares sprinted to a new high at $109. Option premiums inflated and this gives holders of those options an excuse to sell. It may not happen over the next several days or weeks but it will happen. Option premiums will decline.
I personally like Facebook as an investment and I believe it is going a lot higher. However, every stock with a pattern spike like this will suffer profit taking. Everyone that owned the stock over the last quarter will want to take profits. When that happens a new crop of buyers will eventually emerge and they will take it to new highs. The analyst consensus estimate is around $144 for Facebook over the next 18 months.
The 2017 $115 LEAP call is $13.15 today. The breakeven on that call at expiration would be $128.15 but obviously, we do not have to hold it until expiration. We do not want to hold it at all today because once Facebook begins to decline or the market rolls over for a couple weeks we could see Facebook back at $100 or even $95. We do not know where it is going but we do know that it has suffered 10% declines multiple times in the past. After hitting a new high so far out of the trend, the odds are good it will return to the prior pattern.
The midline of the pattern would be about $98 and the bottom of the pattern about $90. Note how many times it has traded at the bottom over the last two years. We do not want to be holding a long-term LEAP call while that retracement occurs.
To recap, LEAPS are best utilized on index ETFs on significant market drops. I am not talking about a couple hundred Dow points but the bigger the drop the better. The August 2015 crash would have been perfect to launch some 2017 LEAP positions as would the October 2014 drop.
LEAPS are best used in normal markets on low volatility stocks that have corrected significantly on sector specific or stock specific reasons. The decline in the energy sector is a good example. Buying a 2017 LEAP today on an ETF like the Oil Exploration XOP would be a good strategy. The 2017 $45 LEAP call is $4.00 and we could easily see the XOP back at $55 or higher by the end of 2016.
You can also look at LEAPS as a lottery ticket. At $3 that is a $300 bet that the market/stock will be significantly higher 12-14 months from now. While not all lottery tickets are winners the ones that do win sometimes payoff big.
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