Your Best Option for Cashing In on LEAPS

You should rarely bet on long-term options in a taxable account, Fool contributor Tim Beyers says in the following video.

Why? Taxes. LEAPS, or long-term equity appreciation securities, are options to buy (or sell) stock at a certain "strike" price within a defined time period -- 18 months to two years is typical.

Profits collected after holding LEAPS for at least a year and a day are taxed at long-term capital-gains rates when the securities are held in a taxable account. Holding them in a retirement account defers taxes entirely -- a nice bonus if you've had a big winner that needs cashing out before the contract expires.

Tim has seen this process at work, cashing in a 10-bagger in Netflix LEAPS held in his SEP-IRA. Now, he's looking at Pandora Media (NYSE: P  ) LEAPS as a potential new buy, figuring that the company -- whose business depends on helping listeners discover new music -- occupies a defensible niche between single-track and album stores such as iTunes and Amazon.com and playlist organizers such as Spotify.

Buying 2016 LEAPS at a $30 strike would cost roughly $12.50 apiece. Thus, were Pandora to rise to, say, $60 on or before January 2016, Tim says he'd be sitting on at least a double. If he's right, holding in the IRA would allow Tim to realize the gains at any time without kicking off a taxable event.

Now it's your turn to weigh in. What's your strategy for cashing in on LEAPS? Do you use them in your retirement account? A taxable account? Please watch the video to get Tim's full take and then leave a comment to let us know whether you would buy, sell, or short Pandora stock at current prices.

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  • Report this Comment On January 31, 2014, at 1:08 PM, Gonzhouse wrote:

    LEAPS held in taxable accounts get the same tax treatment as regular stock: if held for greater than 1 year and 1 day both are eligible for long term cap gain (LTCG) treatment, LEAPS held in non-taxable accounts are, as you said, not taxed when closed. However, they are taxed when the proceeds are withdrawn and at ordinary income tax rates. It actually makes sense to hold LEAPS in a taxable account if you plan on holding more than 1 year because you get LTCG treatment versus ordinary income treatment when withdrawn from a non-taxable account. (This assumes you make a profit on the LEAP; if you lose money, it is almost imperative the LEAP be in a taxable account to realize an offset to taxable profits.)

    Either way, your strategy should not be solely driven by income tax considerations. LEAPS are a highly leveraged and therefore riskier way to profit from a stock's appreciation at a lower outlay of funds than if you owned the stock outright. The beauty of LEAPS is it gives your investment thesis enough time to play out without worrying about idiotic short-term analysts projections; short-term noise has little impact on LEAP prices.

    To answer your question, I use them in both taxable and non-taxable accounts. I use non-taxable accounts when I feel very strongly about a stock's appreciation potential and I don't have a lot of available funding in the account but I want to get in the stock in a bigger way.

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