Create a LEAPS Portfolio

Long-term equity anticipation securities – or LEAPS – are long-term options that can be used as a substitute for holding the underlying stock. LEAPS offer investors a way to create a large portfolio of stocks at a fraction of the cost with a more limited downside. This article will explore how average investors can create a diversified stock portfolio with LEAPS options in order to leverage their returns and reduce their risk.

Introduction to LEAPS

Investors looking to create a portfolio of LEAPS will only need to be familiar with one type of option – the LEAPS calls. These options give investors the right (but not obligation) to purchase a set number of shares at a set price at or before a set date in the future.

Here’s an example of RUT’s LEAPS option chain from OptionsXPress.com:

Investors looking to purchase 100 shares of RUT (one contract) between now and January ’09 at $750 can purchase the right for $7,160 ($71.60 x 100 shares). The breakeven on the position is then $821.60 ($750 + $71.60), which is a 9.6% premium over the current market price. Investors considering this LEAPS option must decide if they believe RUT will rise more than 9.6% between now and January ’09.

The good news is that if RUT’s shares rises to say 20% to $893.93, then the LEAPS option’s return will be just over 100%. Meanwhile, the losses that a LEAPS investor can occur is limited to just $7,160. This compares to holders of the underlying stock that would lose even more if the stock dropped below 9.6%. The bad news is that if the stock trades lower than $750, then you will lose 100% of your investment – even if it is just $7,160.

LEAPS can be useful when constructing a portfolio for many reasons:

1. Leverage – LEAPS provide greater leverage than buying stock or even buying stock on margin.
2. Diversification – Purchasing 100 shares of a stock is much cheaper using LEAPS, which means a greater variety of stocks can be purchased.
3. Risk Management – The risk for each trade is limited to the amount of the option, which is often a fraction of the risk taken by stock ownership. Meanwhile, purchasing LEAPS even more in the money can reduce the risk of worthless expiration.

Constructing a Portfolio

Investors that desire to create a portfolio of LEAPS should be aware that it is a lot more work than a traditional stock portfolio. Choosing LEAPS options involve a lot more factors, including volatility, while the portfolio also requires a lot more follow-up actions since there is an expiration date. However, the rewards can be well worth the effort if investors make the right moves.

LEAPS options perfect for a portfolio have the following characteristics:

1. Low Volatility – Stocks with high volatilities have more expensive options premiums, therefore it is wise to seek options with lower volatility.
2. Diversification – Investors should look for a portfolio of stocks in a variety of industries in order to ensure that your portfolio doesn’t suffer from an unforeseen problem in a specific industry. An average portfolio should also have at least five stocks.
3. Risk Variety – Risk in the stock market is measured by a stock’s beta. It is important to find create a portfolio with an average beta of around 1.0.Lower betas also mean cheaper options.

Once investors have constructed a LEAPS portfolio, there are some follow-up actions that may be required. When LEAPS approach expiration, investors have an important decision. They can either sell the LEAPS option, exercise the option, let it expire worthless, or roll-out the option to a later expiration date. Investors must also make all of the normal decisions associated with a portfolio – when to buy, when to sell, and what stocks to look at.

Conclusions

LEAPS options can be used to create a portfolio of stocks or supplement an existing portfolio. The options inherently allow greater diversification, manageable risk, and higher leverage.

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