by Karim Rahemtulla, Advisory Panelist
Wednesday, September 9, 2009: Issue #1088

So what’s the better investment – stocks or LEAP options?

As I’ve explained in recent columns, LEAPS are long-term options that expire in one to two years or more. So it’s an effective strategy if your outlook is a couple of years ahead at most.

And the best part is that LEAPS allow you to participate in the moves of the underlying stock (either up or down), for a fraction of what it would cost you to buy the shares outright.

So let’s compare a regular stock investing strategy with LEAP options, using the following guidelines. This is purely as an example…

The Stock Strategy

Here are the initial parameters of the stock strategy example:

• Cash to invest: $1,000,000
• Stocks to hold: 20 – Buy 1,000 shares of each, priced at $50 a share
• Timeframe: Two years
• Stop-loss: 20%
• Upside target: 30% across the board over two years (from $50 to $65)

Given that we’re looking for a 30% gain from each position, our maximum profit is $300,000. And our 20% stop-loss means the maximum loss would theoretically be $200,000.

The LEAP Strategy

Basically, we’re going to replicate the parameters above using LEAP options instead of regular shares.

• Strike price: $50 for each stock
• Cost of LEAP: $6. That’s $6,000 for each at-the-money LEAP.
• Timeframe: Two years
• Stop-loss: None
• Upside target: 30% on the underlying stocks (from $50 to $65)

Based on that guide, we’ll invest a total of $120,000 in the LEAPS positions in order to replicate the share position.

So right off the bat, that’s $880,000 less than we’d shell out for the shares outright. We’ll dump it in an account that yields 2% interest per year, which will generate about $30,000.

Stocks vs. LEAPS: Who Wins?

• The Stock Portfolio: Based on the $65 target being achieved for the stocks after two years, the portfolio will be worth 30% more ($1,300,000). Remember, though, we had $1 million at risk and capped our loss at $200,000, given the 20% stop-loss.
• The LEAP Portfolio: With each stock sitting at the $65 target price, each LEAP option is worth $15 – a 150% gain from the $6 we paid for each contract.

The combined portfolio would thus be worth $300,000 at expiration – a “net gain” of $180,000 ($300,000 minus the $120,000 we originally invested). But in fact, the actual return is even higher, since we received $30,000 by using the cash we didn’t spend on the stock portfolio to generate income for us. So our actual net outlay has dropped to $90,000 in order to make $210,000 net.

And as for the most we can lose… well, it’s capped at $90,000 – a far cry from the $200,000 at risk in the stock portfolio.

So the question you have to ask yourself, based on the above example, is whether you want to spend $1,000,000 and risk $200,000, or spend $90,000, with your risk also capped at that amount. Your answer will determine whether you are a LEAPS investor or not.

Karim Rahemtulla