You may know that I am a big fan of options, but I am an even bigger fan of Long-Term Equity Anticipation Securities, or LEAPS. These are options that expire in one year, two years or even three years.
I am a fan of LEAPS because they limit my risk to the amount I choose – but what really counts to me is how explosive they can be on the upside and how they can also limit my downside more than possible when investing in stocks.
Over the past few days, I closed two LEAPS positions in my Automatic Trading Millionaire service. One was a strategic win. The other broke even, as we made the best of a bad surprise. Both presented my readers with important lessons in how LEAPS work. And today, I want to share them with you so that you can become a confident and successful options trader.
Lesson One: The Upside
The first example is a position on Bank of America (NYSE: BAC). During the most recent correction, I issued an alert telling my readers to buy Bank of America LEAPS that would expire in January 2020. They had a $27 strike. I made the recommendation on December 20, and we bought in for $2 per contract.
Yesterday, Bank of America reported blowout earnings and the shares moved higher by 5% at the open. I issued a sell at the open, and our options were up 40% on just the morning’s move in Bank of America. We closed the position out officially for a 65% win, with some able to get close to 100%, as the high price for the day was $4.
This win was based on two strategies…
First, you can see how acting on just a 5% gain in the share price resulted in a 40% move in the underlying option.
Second, I sold well before expiration – just 25 days after we bought – because options lose value over time.
It could have gone much differently.
If the option that we bought for the $27 strike had expired at its current price of $3.75, we would have lost money because the intrinsic value would have been only $1.
Now, had we bought the stock on December 20, we would have paid around $24.40. Our risk with a 25% stop loss would have been $6.10, more than THREE times our risk with the LEAPS option.
If we had sold Bank of America yesterday for $27.90, the price it was trading at when we sold our option, the gain would have been 14.3%. That’s not bad for 25 days, but we made almost five times as much with the LEAPS option and limited our downside to less than 9% of the share price.
Lesson Two: The Downside
My second recent trade resulted in a breakeven, or maybe even a small loss. A couple of months ago, I recommended two-year options on Goldcorp (NYSE: GG). At the time, Goldcorp was trading for $10 and our two-year option with a $12 strike price was trading for $1.40.
Last week, gold mining giant Newmont Mining Group (NYSE: NEM) announced that it was buying Goldcorp. Ordinarily, that would be great news for shareholders.
But the price Newmont was paying was in stock, and it was only a 17% premium. In other words, it was a very low offer. Goldcorp shares moved higher on the news, trading up to $10.80. Our option barely budged, and it traded in a range of $1.20 to $1.60 during the day.
I issued a sell at the open when the prices were the highest, knowing that once the market digested the facts, the price would move lower – and it did. By the beginning of this week, the price on Goldcorp was in the low $10s and the option broke below $1.
By offering a price that placed the value on the takeover at around $11.50 at the time of the offer, the upside for our LEAPS became nonexistent. The deal was scheduled to be finalized in the second quarter, and that was our saving grace.
By choosing a long-term option, we kept time value and risk premium on our side. Then, when Newmont offered a price based on its own shares, we also still had the possibility that Newmont’s price would move higher, thereby pushing Goldcorp’s price higher as well.
But the risk was so high that the opposite could happen as well, and since our strike was below the offer price, it was prudent to bail. And bail we did, escaping by the skin of our teeth. Having LEAPS saved us from a total loss: We chose a strategy that put time on our side.
LEAPS are a unique way to invest, especially in this market. We get unlimited upside, and we are able to limit our downside and risk to just a fraction of everyone else’s!