Why Buying LEAPS Instead of Stock Can Be a Smart Strategy
If you are bullish on a certain stock, but don’t want to tie up a lot of capital or take on too much risk, you might want to consider buying LEAPS instead of stock. LEAPS stands for Long-term Equity Anticipation Securities, which are options contracts with expiration dates up to three years in the future. By buying deep in-the-money LEAPS calls, you can effectively control 100 shares of stock with much less money than buying the stock outright, and potentially enjoy higher returns if the stock price goes up.
What Are the Benefits of Buying LEAPS Instead of Stock?
Buying LEAPS instead of stock has several advantages, such as:
- Leverage: By paying a fraction of the stock price, you can control a larger number of shares with LEAPS. For example, if a stock is trading at $50 per share, and you buy a LEAPS call with a strike price of $40 and an expiration date two years from now, you might pay $15 per contract. This means you can control 100 shares of stock for $1,500, instead of paying $5,000 to buy the stock outright.
- Lower Risk: Buying LEAPS instead of stock also limits your downside risk. If the stock price drops below the strike price of your LEAPS call, you can simply let the option expire worthless and lose only the premium you paid. However, if you bought the stock and it drops below your purchase price, you would lose more money. For example, if the stock drops to $30 per share, your LEAPS call would be worth zero, but your stock would be worth $3,000, resulting in a loss of $2,000.
- Flexibility: Buying LEAPS instead of stock gives you more flexibility to adjust your position as the market conditions change. You can sell your LEAPS call before expiration to lock in profits or cut losses. You can also roll your LEAPS call up or down to a different strike price or expiration date, depending on your outlook for the stock. For example, if the stock rises to $70 per share, you can sell your LEAPS call for $30 and buy another one with a higher strike price or longer expiration date to capture more upside potential.
What Are the Drawbacks of Buying LEAPS Instead of Stock?
Buying LEAPS instead of stock also has some disadvantages, such as:
- No Dividends or Voting Rights: By buying LEAPS instead of stock, you forfeit shareholder benefits such as dividends and voting rights. This means you miss out on the income and influence that owning shares can provide.
- Time Decay and Volatility: Buying LEAPS instead of stock also exposes you to time decay and volatility. Time decay refers to the loss of value of an option as it approaches expiration. Volatility refers to the fluctuation of the option price due to changes in the underlying stock price and market sentiment. Both factors can erode the value of your LEAPS call if the stock price does not move in your favor.
- Liquidity and Bid-Ask Spread: Buying LEAPS instead of stock also requires you to deal with liquidity and bid-ask spread issues. Liquidity refers to the ease of buying and selling an asset without affecting its price. Bid-ask spread refers to the difference between the highest price someone is willing to pay for an asset and the lowest price someone is willing to sell it for. LEAPS tend to have lower liquidity and wider bid-ask spreads than stocks, which means you might have trouble finding buyers or sellers for your options at favorable prices.
Conclusion
Buying LEAPS instead of stock can be a smart strategy if you are bullish on a particular company’s stock, but want to use less capital and take on less risk. However, buying LEAPS also comes with some drawbacks that you need to be aware of before making a decision. You should weigh the pros and cons carefully and do your research before buying any options contracts.