This week, we're going to explore the profit potential of LEAPS. LEAPS, or Long Term Anticipated Securities, are options whose expirations extend much further into the future than normal call and put options. The advantage of LEAPS is that they allow you to make trades with intermediate to long-term outlook while putting out a fraction of the cost of being long the underlying issue.
Description of LEAPS
A LEAP option can allow up to 24 months of time for investor speculation although we normally utilize only a portion of that time in the LEAPS Trader. LEAPS options expire in January of each year but can be purchased and sold at any time.
A LEAP option has a stated strike price generally in $5 increments corresponding with the price of the underlying security.
For instance a stock trading at $50 will have available strike prices at $5 increments from approximately $40 to $75.
Using GE as an example at $36.50 in Dec-2004 the prices for GE LEAPS are shown below.
Jan-06 $30 $7.30 Jan-07 $8.20
Jan-06 $35 $3.60 Jan-07 $4.90
Jan-06 $40 $1.30 Jan-07 $2.65
Jan-06 $45 $0.40 Jan-07 $1.30
With LEAPS your risk is limited to the price you pay for the option but unlimited as to potential gains. Using the GE example above you can see that buying the Jan-07 $40 LEAP for $2.65 would give you two years of price appreciation potential for GE for a very modest price.
With LEAPS everything is priced in 100 share lots. Using the GE Jan-07 $40 LEAP at $2.65 it would cost you $265 plus commission to enter the position. That is your total risk for the rest of the trade. If GE fell to $20 and your LEAP expired worthless your total cost would still only be $265.
Your upside potential is unlimited. Should the economy explode and GE run to $75 over the next two years the Jan-07 $40 LEAP would rise to $35 in value, $3500 per LEAP contract.
At expiration in January-2007 you have the option to sell the leap outright for any gain in price or exercise the LEAP and own the stock at $40. It is your choice, you are in control.
LEAPS are a very conservative investment but they still have risk, which is limited to your investment. Your risk is that the stock will not rise over your strike price during the remaining time period.
Your risk is greater the farther away from the current stock price you chose to purchase a LEAP. For instance, purchasing a $40 LEAP on GE would be a fairly safe bet but purchasing a $70 leap would be foolish. The odds of GE doubling in price over the next two years are far less than simply increasing $10. Your actual cash at risk would be much less at $70 with the LEAP costing only about $0.10 ($10 per contract) but the odds of the $70 price being reached are very small.
Investors must weigh their anticipation of gains in the stock price against the price of the various strikes when determining which strike price to purchase.
There are multiple strategies we employ at LEAPS Trader to reduce our cost in the position and in some instances the final cost will be zero. Highly volatile stocks will carry higher premiums than the GE LEAPS profiled above. This is due to the greater chance of a larger move in the stock price. In LEAPS a low price is not always a better investment and most times a high price is also less desirable. We endeavor to find the LEAPS at the right price to produce a high probability of profit.
On March 8th, OptionInvestor.com newsletter LEAPS Trader recommended the following trade:
BTU - $46.20 - Peabody Energy
Peabody was knocked back to earth this week after coming very close to a new high the first week of March. $52 appears to be resistance and the 100 dma at $43 is support. Peabody split 2:1 baco on Feb 23rd and should find new buyers once the sector recovers. Peabody profits are not related to the price of oil and coal prices are continuing to rise. Summer cooling season is just ahead and BTU is going to be a long term hold. We bought the 2008 LEAP in anticipation of a long term position.
Company Info:
Peabody Energy Corporation (Peabody) is a private-sector coal company in the world. During the year ended December 31, 2004, the Company sold 227.2 million tons of coal. It sells coal to over 300 electricity generating and industrial plants in 16 countries. The Company owns, through its subsidiaries, majority interests in 32 coal operations located throughout all the United States coal producing regions and in Australia. Most of the production in the western United States is low-sulfur coal from the Powder River Basin. In the West, it owns and operates mines in Arizona, Colorado, New Mexico and Wyoming. In the East, it owns and operates mines in Illinois, Indiana, Kentucky and West Virginia. The Company owns four mines in Queensland, Australia. Most of the Australian production is low-sulfur, metallurgical coal. In addition to the mining operations, the Company markets, brokers and trades coal.
Breakdown target $48.00 hit 3/07
Position: 2008 $55 LEAP Call LLW-AK @ $9.50
By April 9, BTU was up 4.11 points, representing a 8.8% gain in the price of the stock. The 2008 $55 Leap was up 2.2 points from 9.50, a 23% growth in the value of our position (see the leverage?). We bought the 2008 LEAP in anticipation for a long-term position, as BTU's profits are not based on the price of oil, and coal prices are set to rise with gas prices.
From the looks of it so far, we are not going to be disappointed.
About LEAPS Trader:
LEAPS Trader scans our universe of stocks on a daily basis to produce potential investment opportunities where there is limited risk and maximum upside potential. Using our limited risk strategies allows investors to position themselves in stocks that offer significant upside potential and still be able to sleep at night. The average duration for a position is three months. LEAPS Trader utilizes technical and sentiment indicators to profit from market cycles without excessive trades. If you are a Type-A trader that needs to trade daily then LEAPS Trader is not for you. Our typical portfolio is 8-12 positions and will turnover 2-3 times per year. The object of the game is putting more profit in our pockets not making our brokers richer.
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