Despite their short-term allure, you can use certain options to create longer-term mini “portfolios” within a portfolio. And there could be beneficial tax considerations to boot.
Most investors have categorically placed options into a bucket designated for short-term, complex, and risky investments. However, in light of market volatility and systemic risks that crumbled the stock markets a few years ago, that perception is changing. Finding ways to reduce risk has risen to the top of investors’ punch lists when choosing what to include in their portfolios. One way may be to consider options—in particular, longer-term options.
On October 5, 1990, the Chicago Board Options Exchange (CBOE) began listing LEAPS® (Long-term Equity AnticiPation Securities). LEAPS offered a critical component to help ease the transition from stock trading to options trading: time. Previously, option traders could typically expect their positions to expire within several months. LEAPS helped traders hold an option position as far out as 39 months to expiration. For the average investor, this meant the line between owning stock, and owning options, had been blurred. But some new option strategies emerged.
The Leverage Factor
You can often find affordable LEAPS options that in theory have at least a “delta” of 90—meaning that for every dollar the stock rises, the option will likely rise 90 cents. (Delta measures how changes in the price of the underlying asset affect an option’s value.) Likewise, for every dollar the stock drops, the option will likely drop 90 cents. While this isn’t a perfect ratio, it seems to closely mimic the stock’s movement. Likewise, it may be a fair trade-off when you consider the “savings” per position —since you went with “controlling” the stock position instead of “owning” the stock position— from not having to purchase the entire underlying. Plus, your absolute risk has been reduced.
Just how much of a savings can you achieve by purchasing a 90-delta LEAPS option rather than 100 shares of the stock? Figures will vary, but it’s possible to find 90-delta LEAPS that might cost between 25% and 50% of a prevailing stock price.
If you’re paying 50% stock value for an option, you might be thinking that’s the same as buying the stock on margin, right? Well, yes—but mostly no. While buying stock on margin means you’ll generally part with 50% of the capital you’d normally commit in a cash account, you’re still potentially risking 100% of the total commitment to the trade. And if the stock drops far enough, you’ll probably get a margin call. Whereas, your absolute risk in buying LEAPS, is typically limited to the purchase of the option. (Read: no margin calls)
The Interest Factor
Remember, when you buy a stock on margin, in most cases, you have to put up at least 50% of the stock price. Margin may be as low as 30% at TD Ameritrade depending on the stock. Who picks up the rest? Your broker. And whenever there’s a loan, there’s usually interest.
But what do interest rates have to do with buying LEAPS, if you’re not borrowing on margin to buy them? There’s an interest component built into the price of the option. Moreover, the interest you see in a LEAPS option is generally the market’s interest rate, not your broker’s rate.
Constructing A Leaps Portfolio
You can’t buy LEAPS on every stock that lists options. But just about every broad-based index and the majority of liquid, optionable stocks have them. This potentially helps you replicate customized portfolios for a fraction of the cost of a respective stock basket.
Suppose you want to create a LEAPS portfolio with three of your favorite banking-sector stocks:
STEP 1: FOR EACH STOCK SYMBOL, FIND THE FIRST AVAILABLE LEAPS SERIES As of the writing of this article, these would be the January 2013 options.
STEP 2: SCROLL THROUGH THE OPTION CHAIN UNTIL YOU HAVE LOCATED A CALL OPTION WITH ABOUT A 90-DELTA. This part requires a bit of discretion since you won’t always find an option with a delta that is exactly 90. Some deltas may be a little higher, and some may be lower. That’s OK, as long as you’re in the ballpark. To illustrate, see Figure 1:
In the case of our FAHN example, you can buy the 20-strike calls, which have a delta of approximately 90 (noted as 0.895 in the option chain pictured), for just under half the price of the stock. However, if you’re willing to make slightly less profit per dollar gain in FAHN, you can choose an option with a slightly smaller delta. The 23-strike calls have a delta of 87, and they cost almost three dollars less than the 20 calls.
STEP 3: MULTIPLY THE PRICE OF YOUR OPTION BY 100 TO DETERMINE HOW MUCH YOU WILL PAY. Suppose you buy the 23-strike calls for $15.50. You can expect to pay $1,550 per contract for the FAHN component of your LEAPS portfolio. Compared to the approximately $3800 you might spend buying 100 shares of the stock, in this case LEAPS would allow you to control 100 shares of stock for about 40% of the current stock price, before taking into account transaction costs.
STEP 4: RINSE AND REPEAT THE PROCESS FOR THE REMAINING STOCKS. Once you have repeated the three previous steps for the remaining bank stocks you want, you’ve essentially created a portfolio using LEAPS at a fraction of the cost of purchasing the stocks outright, and in many cases, on margin costs.
The Possible Tax Break
LEAPS are considered securities because they fit the Securities and Exchange Commission’s (SEC) definition of an asset with a life span longer than nine months. As such, you may be able to defer some of your capital gains for holding securities longer than 12 months, which could allow for some possible savings. However, everyone’s situation is different. So make sure you talk to your tax advisor for the final word.
Know Your Dividends
While stockholders get dividends, call option holders do not. The good news is call options typically price in the lack of a dividend. Nevertheless, you may want to be on the lookout for dividends during the life of your trade.
Occasionally, if an option is too far in the money, it may not have enough wiggle room to adjust downward for the dividend. You may have to exercise the option early, or be willing to lose a value roughly equivalent to the dividend payment.
Are you close to the decision point? If on the day before the ex-dividend date, the dividend appears to be greater than the value of the put option (yes, the put) of the same strike and expiration, you may want to call your broker.
Overall, the introduction of LEAPS options as a stock substitute has allowed less-capitalized investors to construct affordable portfolios by using leverage. LEAPS also helps well-capitalized investors to increase the number of shares they control, and invest in “mini-portfolios” to diversify their holdings.