Investment capital usually needed for huge investments in large-cap growth stock players, like Netflix. The plays are also relatively riskier. They are touted to provide huge returns, but the ride can be very bumpy. For most traders, the earmarking of a significant amount in such volatile stocks is daunting and financially unfeasible.
Fortunately, there is a very strong and easy-to-implement strategy for options positions, the LEAPS (Long-Term Equity Anticipation Securities) strategy. LEAPS allow a person to invest in growth stocks using long-term options as opposed to purchasing the shares. Long-term options allow traders to reduce their up-front capital and still benefit in case of a rise in the stock prices.
In this article, we will get into the nitty-gritty of this simple options trading with LEAPS and see how you can double your returns on large-cap stocks using less capital while reducing your risk. And at the end of the article you will learn how to apply this options technique towards achieving maximum stock market gains effectively.
LEAPS Options
An LEAPS is actually an extended call option, with an expiration date of a year or more in advance. This enables investors to invest in the movement of the price of the stock without owning actual shares. Buying a call option on a LEAPS option costs only a portion of the price of the actual stock. As such, it forms an attractive strategy for traders in high-growth stocks but who may not have enough capital or prefer to minimize their financial exposure.
Main Benefits of LEAPS
- Lower cost of entry: You need to pay less capital upfront to get LEAPS compared to purchasing shares.
- Higher returns: Since the capital invested upfront is lower, your returns may be a lot higher.
- Reduced risk: Because you stand to lose less—the price of the option, not the full price of shares—the loss if the stock under-performs is limited.
How to Use LEAPS to Increase Profit
For instance, let us take Netflix as an example of how LEAPS works. Rather than spending full price for Netflix shares, a trader can invest in the LEAPS call option to essentially have exposure to Netflix’s price movements without having anything close to actual cost. Here’s how it would look in practice:
- Select the Stock: Select a growth stock with high potential and high volatility.
- Select an In-the-Money Call Option: Select a LEAPS call option with a strike price much lower than the present market price of the underlying stock. This will ensure that the option will be in-the-money should the price of the stock advance.
- Purchase the LEAPS Option: Purchase the LEAPS option that expires more than a year into the future. If the stock price moves higher, then your LEAPS option will be worth more, and you can realize the profit on the stock without ever having to own the stock.
- Monitor and Roll Over the Option: When the option is near expiration, sell the option and buy a new LEAPS with a new expiration date and an in-the-money strike price. This rolling strategy allows you to continue collecting that nice earnings without holding the stock directly.
Example of a LEAPS Campaign Using Netflix
Assume you had started this LEAPS campaign back in June 2019:
- Instead of spending $366.94 for a share of Netflix, you spend $18,500 for a LEAPS call with a $195 strike price—less than half the share price.
- Price Movement Over Time: Netflix’s price falls but then rises to $450 by June 2020. By then, the LEAPS call is worth about $25,315, resulting in a tremendous rate of return in comparison to your base cost.
- Roll Over to New LEAPS: At expiration, sell the LEAPS option, lock in any gains achieved, and use those proceeds to purchase a new LEAPS utilizing a similar strategy—half stock price and at least one year from expiration.
For example, over a multi-year period, this strategy may actually double returns compared to just a buy-and-hold approach on the stock. It is both a return-on-equity capture mechanism but also reduces capital invested and limits losses when stocks are going down in price.
Why LEAPS Outperform Buy-and-Hold
The LEAPS strategy holds advantages over the more conventional buy-and-hold approach in the following ways:
- Capital Efficiency: Spending only a small percentage of your capital frees those dollars to invest elsewhere or place other LEAPS trades.
- Exposure: If a stock collapses in value as Netflix did during the 2022 tech sell-off, your exposure to loss is capped at the option, not massive losses. Had you continued holding the shares, that would have been disastrous, but with LEAPS, the damage is insured.
- Potential for Higher Return: In a favorable market condition, LEAPS can multiply your returns. Since you risk less capital, your potential return on investment is higher compared to buying shares outright.
Risks of the LEAPS Strategy
While LEAPS provide you with higher returns, they carry some risks:
- Time Decay: Options lose value as they approach expiration. If the stock does not perform up to expectations before that time expires, the option may expire worthless.
- Minimal Upside Risk: If you choose to exercise the LEAPS option and acquire the equity, then you will most certainly miss out on later upside gain.
But if used properly and rolled over prudently, the benefits of the LEAPS strategy are mostly greater than the risk in respect of long-term growth investors.
Conclusion
In general, LEAPS provide a relatively simple options strategy that can more than double the returns from your stocks without having to increase your capital and with a controlled risk. More important, traders may gain access to large-cap growth stocks with less capital and greater profit by investing in long-term in-the-money call options. That is a beautiful characteristic of using LEAPS—the approach works like a charm for traders when the economy experiences growth. The trader can capture positive gains minus the full downside from stock volatility, which would explain why the trader is well ahead in performance.
In any case, whether you are a new trader or an experienced investor, the inclusion of LEAPS in your portfolio acts as a good method for much better returns without exposure to excessive risk. Like any other trading methodology, it is bound to develop the required skill and discipline through this approach to bring all returns on investment.