Using LEAPS as a Stock Substitute

Long-term Equity Anticipation Securities – or LEAPS – can be extremely useful as a stock substitute for long-term investors. They can offer an attractive alternative to investors purchasing stock on margin while also allowing investors to participate in the markets with limited upfront cash requirements and limited risk. LEAPS are putting power of options in the hands of investors!

LEAPS are best used as a substitute in three situations: (1) When an investor doesn’t have the funds available to buy the underlying stock, (2) when an investor has the funds but is hesitant to buy the stock, or (3) when an investor wants the leverage of margin but without the risk.

Situation #1: When an Investor Doesn’t Have the Funds

LEAPS can be a cost-effective way to gain exposure to a stock’s upside (and downside) and save when they don’t have the money to purchase the underlying. The trade-off is that a lower effective buying price requires a higher initial investment. Let’s take a look at an example of 2-year LEAPS taken from the great book Understanding LEAPS:

XYZ Stock Price: $111.00
Annual Dividend: $1.00
100 Call Option: $33.30
140 Call Option: $18.80

Using this information, investors can construct a simple table to illustrate the trade-off:

Strike Price	Option Premium	Effective Purchase Price	Purchase Price as a % of Stock Price	Capital Required as a % of Stock Price
$100	$33.30	$133.30	120%	30%
$140	$18.80	$158.80	143%	16.9%

Purchasing LEAPS gives investors immediate exposure to the underlying stock and two years to save up the money necessary to exercise the option. Since the goal is to eventually purchase the underlying, investors should purchase as low of a strike as possible in order to lower the amount that they will need to save up to acquire the underlying stock in the future.

Situation #2: When an Investor is Hesitant to Purchase a Stock

Investors who are hesitant to purchase a stock can use LEAPS to hedge their cash in order to mitigate risk. A relatively small amount of cash can be used to purchase LEAPS on the stock with the rest of the money put into T-Bills or another secure investment to return a set amount. The result will be a hedged position that entails less risk than outright stock ownership.

Using the same examples above, we can construct a simple table to illustrate the trade-offs here too (assuming a 5% interest rate on the T-Bill):

Strike Price	Cash Available	Option Premium	Cash to Invest	Interest Earned	Ending Capital	Effective Purchase Price	Cash Deficiency
$100	$111	$33.30	$77.70	$7.96	$85.66	$133.30	$14.34
$140	$111	$18.80	$92.20	$9.45	$101.65	$158.80	$53.28

Purchasing the $100 call would cost $33.30, leaving the investor with $77.70 to invest. The $77.70 would generate $7.95 in interest over two years. Therefore, in the worst case scenario, the investor would have ending capital of $85.66 (the $77.70 invested plus the accrued interest).

Should the investor decide to exercise the call, the effective purchase price would be $133.30 (the $33.30 paid for the call plus the $100 necessary to exercise the option). In the event of a call, there will be a cash deficiency of $14.34 – that is, the investor will have to come up with that amount to cover the option’s exercise price of $100 per share.

The idea behind this strategy is to allow investors to realize upside appreciation while mitigating a lot of their risk. Using LEAPS and T-Bills, it is easy to see just how simply a position like this can be constructed.

Situation #3: An Investor Who Wants a Margin Trading Alternative

Purchasing stock on margin involves investors borrowing money from their broker to finance part of their stock purchase. The borrowed money gives the investor leverage that can equate to a higher return on investment. Simply put, the less money you have to personally invest to make the same return will increase the percentage gain on your initial investment.

Unfortunately, there is one thing that makes buying on margin risky: margin calls. There is a Wall Street sang that goes something like: Buying stocks on margin means you can buy twice as much stock as you can afford. If the stock you purchase declines, your will receive a call from your broker asking you to either put up more money or they will sell your stock at an often steep loss.

LEAPS can help investors achieve leverage on their trades without the risk of a margin call. The returns may not be as high, but the possibility of margin calls is eliminated, the downside risk is limited, and the financing costs are locked in. Often times, this is a trade-off that makes a lot of sense for the average investor.

The reason that buying LEAPS slightly underperforms buying stock on margin deals with the issue of time premium. Often times, the time premiums on long-term options are slightly higher than the financing cost of the margin loan. However, if the stock drops, investors will be glad that they chose to use LEAPS instead of a loan from their broker!

Conclusions

LEAPS are extremely valuable securities that can be of great use for many investors:

1. Investors that do not have the funds to buy a stock they would like to hold should consider purchasing LEAPS and then saving money to exercise the options. The trade-off is that lower effective buying prices require higher initial investments.

2. Investors who have the funds but are hesitant to purchase a stock for any reason should consider buying LEAPS along with a T-Bill. The trade-off is that lowering the effective purchase price involves taking on more risk.

3. Investors who currently purchase stock on margin should consider purchasing LEAPS – the returns may not be as high, but the possibility of margin calls is eliminated, the downside risk is limited, and the financing costs are locked in.

Additional Resources

Trend Trading on Steroids - Learn how to identify stable trending stocks and utilize LEAPS to multiple profits while reducing risk.

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