Saturday, May 1, 2010

Time to lever up?

LEAPS, or Long-term Equity AnticiPation Securities, have recently grabbed my attention. LEAPS are simply a long-term call option, or in other words the right (but not obligation) to buy a stock at some point in the future at a predetermined price.

Here's an example: let's say stock XYZ is being investigated for some alleged wrongdoing. Currently the stock is trading at $100 a share, but it's worth $200 assuming they're innocent. However, if they're guilty the stock is probably only worth $50. If I were to purchase XYZ common stock, based on my current portfolio size, I'd probably buy $10,000 - and I'd either lose $5,000 or gain $10,000.

However, let's say I could buy XYZ LEAPS (expiring 1/2012) with the following terms: a strike price of $150 and a contract price of $5. In other words, for $5 I reserve the right to buy one share of XYZ for $150 anytime between now and 1/2012. If I were to invest $5,000 in XYZ LEAPS I could potentially lose it all if the stock never gets to $150 (which is the same amount I'd lose with the common stock).

But what happens if the stock goes to $200? Well, since I invested $5,000 I have the right to buy 1,000 shares at $150. Since I could immediately sell them for $200, I'd realize a $50,000 profit! So, with LEAPS I'd either lose $5,000 or gain $45,000 (50K profit less the initial investment of 5K).

Obviously this is a very simplistic example - the real world is much murkier. However, the economics of buying LEAPS can be extremely attractive, and in some cases it just makes more sense. I'm specifically looking at Jan. 2012 LEAPS for EXC and MON and as always I'll post about anything I decide to do.