Using LEAPS Instead of Stock to Generate Huge Returns

If you are bullish on a particular company's stock, it is possible to structure your investment with LEAPS so that a rise of, say, 50% could translate into a 300% gain for you without borrowing money on margin. Of course, this strategy is not without risks and the odds are very much stacked against you. Used foolishly, it can wipe out your entire portfolio in a matter of days. Used wisely, however, it can be a powerful tool that allows you to leverage your investment returns without borrowing money on margin.

The strategy is based upon acquiring long-term stock options known as LEAPS, which is short for "Long Term Equity Anticipation Securities". Put simply, a LEAP is any type of stock option with an expiration period longer than one year. It allows you to utilize a smaller degree of capital instead of purchasing stock, and earn outsized returns if you are right on the direction of the shares.

Perhaps it's best to understand how to use LEAPS by way of an example. For now, we'll use shares of General Electric given the enormous size of the company and the fact that virtually everyone in the world is familiar with the firm.

Right now, shares of GE are trading at $14.50. Imagine that you have $20,500 to invest. You are convinced that General Electric is going to be substantially higher within a year or two and want to put your proverbial money where your mouth is. You could, of course, simply buy the stock outright, receiving roughly 1,414 shares of common stock. You could leverage yourself 2-1 by borrowing on margin, bringing your total investment to $41,000 and 2,818 shares of stock with an offsetting debt of $20,500 but if the stock crashes, you could get a margin call and be forced to sell at a loss if you are unable to come up with funds from another source to deposit in your account. You will also have to pay interest, perhaps as much as 9% depending upon your broker, for the privilege of borrowing the money.

Perhaps you are unsatisfied with this level of exposure. Given your conviction (whether it's well founded or not is another story!) you might consider utilizing LEAPS instead of the common stock. You look to the pricing tables published by the Chicago Board Options Exchange and see that you can purchase a call option expiring the third weekend in January of 2011 � nearly 20 months and 3 weeks away � with a strike price of $17.50. Put simply, that means that you have the right to buy the stock at $17.50 per share. For this right, you must pay a fee, or "premium", of $2.06 per share. The call options are sold in "contracts" of 100 shares each.

You decide to take your $20,500 and purchase 100 contracts. Remember that each contract covers 100 shares, so you now have exposure to 10,000 shares of General Electric stock using your LEAPS. For this, you have to pay $2.06 x 10,000 shares = $20,600 (you rounded up to the nearest available figure to your investment goal). However, the stock currently trades at $14.50 per share. You have the right to buy it at $17.50 per share and you paid $2.06 per share for this right. Thus, your breakeven point is $19.56 per share. That is, if General Electric stock is trading below that price when the option expires nearly two years from now, you will suffer a loss of capital. If GE stock is trading below your $17.50 call strike price, you will lose 100% of your invested money. Hence, the position only makes sense if you believe that General Electric will be worth substantially more than the current market price � perhaps $25 or $30 � before your options expire.

Say you are correct and the stock rises to $25. You could call your broker and close out your position. If you chose to exercise your options, you would force someone to sell you the stock for $17.50 and immediately turn around and sell the shares you bought, getting $25 for each share on the NYSE. You pocket the $7.50 difference and back out the $2.06 you paid for the option. Your net profit on the transaction was $5.44 per share on an investment of only $2.06 per share. You turned a 72.4% rise in stock price into a 264% gain by using LEAPS instead of stock. Your risk was certainly increased, but you were compensated for it given the potential for outsized returns. Your gain works out to $54,400 on your $20,600 investment compared to the $14,850 you would have earned.

Had you chosen the margin option you would have earned $29,700 but you would have avoided the potential for wipeout risk because anything above your purchase price of $14.50 would have been gain. You would have received cash dividends during your holding period, but you would be forced to pay interest on the margin you borrowed from your broker. It would also be possible that if the market tanked, you could find yourself subject to a margin call as we warned earlier.

The Temptation of LEAPS

The biggest temptation when utilizing LEAPS is to turn an otherwise shrewd investment move into an outright gamble by selecting options that have unfavorable pricing or would take a near miracle to hit strike. You may also be tempted to take on more time risk by choosing less expensive, shorter-duration options that are no longer considered LEAPS. The temptation is fueled by the few, extraordinarily rare instances where the speculator made an absolute mint. Witness the Wells Fargo June 2009 $20 calls. Had you put $10,000 in them back during the March meltdown, you would have generated an unbelievable return, bringing your position to a market value of more than $1,300,000 in only a few weeks as Wells stock skyrocketed from less than $9 per share to more than $28 a few days ago.

The lesson should be obvious: Using LEAPS is not appropriate for most investors. They should only be used with great caution and by those who enjoy the game, have plenty of excess cash to spare, are willing to lose every penny they put into play, and have a complete portfolio that won't miss a beat by the losses generated in such an aggressive strategy.

Don't delude yourself � using LEAPS is most often a form of outright gambling. As Benjamin Graham said, such practices are neither illegal, nor immoral � but they are certainly not fattening to the wallet.