Despite my general aversion to options - mainly because I have no success with them - they can be a very useful tool when employed prudently and opportunistically. One particular facet of options trading that is interesting is the use of long-term equity anticipation securities, commonly known as LEAPS
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Time Is on Your Side ... Sort Of
LEAPS are options with a longer expiration date, typically up to two years. The instant attraction of these instruments is time, because time is one of the most, if not the most, critical aspect of options use. It's very common for users of options to make the right bet, but because of the time of the option, even the right bet can lead to a loss. And with options, that loss can easily be 100% of the invested capital. Hence, a LEAP offers investors a little more cushion against time expiration.
Nevertheless, no investment should ever be made unless a significant value proposition exists. As such, no LEAP option should ever be underwritten on any security unless it too offers an excellent value proposition. However, when carefully selected, LEAPS may be a worthwhile instrument. As with all options instruments, the benefits are a reduced capital requirement, otherwise known as leverage. The upside can be multi-fold return against a downside of a substantial or complete capital loss. (For more, check out Long-Term Equity Anticipation Securities: When To Take The "LEAP"?)
With hindsight, 2009 would have been an excellent year to use LEAPS. With many quality names up over 50% or more, the returns from LEAPS would have been astronomical. Using LEAPS on names like American Express (NYSE:AXP) or Wells Fargo (NYSE:WFC) would have produced quite a tidy return - over 1000% in some instances.
Today, there are still some names worth considering for January 2012 LEAPS. One I particularly like is the January 2012 $30 calls on construction equipment company Terex (NYSE:TEX). Terex shares trade at $23 and the company is currently still in the midst of brutal cyclical downturn. The company recently sold its mining business and is in the middle of repositioning the business. Terex gets a majority of its revenues overseas and will do quite well when the construction cycle improves. Should that happen in next two years - a very likely possibility - shares will be much higher then. The Jan 12 $30 calls will cost you $4.20 today. If shares are above $34.20 anytime in the next two years, the LEAPS will be profitable.
Pfizer (NYSE:PFE) is another worthy prospect. The shares have done nothing for the past 10 years, even though the company continues to produce tons of cash flow. The new healthcare bill will mean more patients needing medication, a great outcome for Pfizer even if it means agreeing to lower prices. Shares are $19.50 today and the Jan 12 $25 call options are priced at 83 cents. So, if you believe Pfizer will be trading above $26 in the next two years, LEAPS might be a good option here. If the stock hits $30, the gain is more than five-fold.
As great as the potential returns from LEAPS look, always remember the ease of a 100% downside. At times, however, certain opportunities exist that can make the use of LEAPS a very intriguing bet. (For related reading, check out Using LEAPS In A Covered Call Write.)
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