Intelligently Investing in LEAPS

Permanent capital loss for most investors occurs with option investing. But there is one type of equity option that, when used and understood carefully, can offer fantastic potential many times the return.

Invest for the long term
Long-Term Equity Anticipation Securities (LEAPS) is a fancy name for long-term equity options. LEAPS usually extend about two and half years and operate just like a traditional option. They give you the right to buy (we'll stick to call options) a certain stock at a certain price within a certain time.

Most option investors incur losses not because they incorrectly analyzed the bull or bear thesis of a business, but rather because the option expired before the stock price had time to follow the business performance.

Remember: We are investing
If you look for good businesses and try to leverage your returns by investing in long-term options, you are approaching the process backwards. Choosing to invest in long-term options should come as a byproduct of your research efforts.

Before you investigate LEAPS, wait for an unusual investment opportunity to grab your attention. After you find a business that offers a compelling investment opportunity, you can determine whether an investment in a long-term option would benefit you.

The long time frame LEAPS provides investors also offers adequate time for the investment to play out. So to use long-term options wisely and profitably, two conditions in the underlying business should exist:

A compelling equity investment
You wouldn't buy long-term options on severely beaten businesses, such as Fannie Mae (NYSE: FNM  ) or Freddie Mac (NYSE: FRE  ) , simply because they are selling near multiyear lows and you have a gut feeling the shares will somehow find their way back on top. To invest in long-term options prudently, investors need to put in the same disciplined research as they do with equity investing.

Similarly, you want to avoid the long-term options of businesses that aren't trading at significant discounts -- less than 50% to 75% -- of intrinsic value. The reason is simple. Investing in a long-term option of, say, a $30 stock that you feel will be worth $40 to $50 in two years, will not offer a return that would compensate for the risk. 

Case study: Wells Fargo LEAPS
An excellent example of a LEAP candidate was described in You Can Be a Stock Market Genius by Joel Greenblatt. During late 1992 and early 1993, the California-based bank Wells Fargo (NYSE: WFC  ) was trading for around $77 a share. At that time California was going through one its worst real estate recessions. Wells Fargo had a huge concentration of commercial real estate loans, more than its largest competitor at the time, Bank of America (NYSE: BAC  ) .

At the then-current share price, Wells earned nearly $36 a share in pre-tax profits, but the earnings were eaten up by heavy loan loss provisions that seemed overly conservative. During typical real estate conditions, loss provisions were about $6 a share. Assuming a 40% tax rate, the $30 in earnings would be about $18 a share. At a very fair multiple of 10, this meant Wells Fargo could be trading at $180.

Conditions like these make an investment in a long-term option very favorable. The discount to assessed intrinsic value was very high and made an excellent investment. Remember: LEAPS investing is a byproduct of an already excellent investment idea.

At the time, the math was simple. In January 2005, call LEAP options to buy Wells Fargo at $80 a share were selling for $14. If the stock hit $160, the calls were worth $80, representing a nearly 5 to 1 gain. At any price above $94 a share, the worst you could do was break even. At $160, ownership of stock would have yielded a gain of about 100% and required more capital. And if Wells didn't make it, you could lose $77 a share, or about a 1 to 1 loss/win scenario.

Of course, the idea of Wells Fargo going out of business was a very extreme, almost impossible scenario; at that time Wells hadn't shown a loss in its 140-year history. All these positives on the company, in addition to the discount to intrinsic value, made the LEAP investment even more compelling.

Know it cold
Before investing the long-term equity options of a particular business, you must understand the business cold and understand the risk/reward payoff before allocating capital. Investing in LEAPS must be second to an existing, excellent equity investment opportunity and never the other way around.

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