By using a LEAP option strategy, you can participate in much of the upside of a winner, while limiting your upfront cost and therefore, your downside, says Jim Fink.
Jim, the market [has had] a really good rally year-end going through the sweet spot, November to April, but you’re looking at very expensive stocks. Again, I like to think of Google (GOOG) or Apple (AAPL). Is there a way to use call options to cut costs?
Absolutely. You can use long-term call options. They’re called LEAPs. They don’t expire for 18 months to two years, and you can buy them at strike prices slightly below the current stock price, and it will save you a lot of money.
For example, let’s say Apple is currently trading around $400. Instead of buying the stock for $400 a share, which is very expensive, you could buy a call option at the $380 strike price. It’s $20 below the current price, but yet it will only cost you perhaps $40 per share, which is, $40 is almost one-tenth the cost of buying the stock itself.
By buying long-term call options, you do not risk having time decay, which is the bane of all call buyers. You have this extra surcharge from buying a call option, and if you let it come near to expiration, that time value will decay, and you will lose money.
By buying long term, the time value is very muted. There’s very little time decay during the eighteen months to two-year period. So, you can buy that and participate in all of the upside of the stock but for a fraction of the cost.
Well, continuing with this bullish theme: Earnings are coming out. Suppose you think that you’ve got a really positive earnings picture, but you want to protect yourself just in case the company misses. Is there a way you can use options to protect yourself?
Yeah, I see two different ways. One, you can use a long-term LEAP call option to buy the stock at a fraction of the cost, so that if the stock does not do what you want, you will have limited risk.
When you buy a call option, your risk is limited to what you paid for that option. If that option is trading for one-tenth the cost of the stock, even if the stock goes down and you lose money on that option, it will be much less than it would be just from buying stock.
Another possibility is to sell puts at a strike price below the current stock price, so that you leave yourself some cushion. So, if you’re worried that the stock might fall, let’s say with Apple from $400 down to $350, what you can do is sell a $350 put.
In that case, the stock could fall all the way down from $400 to $350, and you still don’t lose anything because your liability is only from $350 and lower. Yet, you can still earn income based on the fact that you think the stock is strong and won’t fall below $350.
So, your risk is limited, but you can still find income in this low-yield environment.
Absolutely, and that’s one of the greatest benefits of options trading.
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