In June 2006, I opened a position that would double in three months.
No, I wasn't investing in wild penny stocks. There were no (ahem) "emerging economies" or sophisticated trading platforms involved, and there were no shady stock promoters to pay off before I could collect my profits. My secret? LEAPs, an acronym for long-term equity anticipation securities.
Or in simpler terms: long-term call options.
Why you should consider a LEAP of faith
More on how LEAPS led to my 120% gain in a quarter in a minute. First, let's talk about what LEAPs are. They're options that combine an intrinsic value with a time value. Foolish colleague Jim Gillies does an excellent job of explaining this concept in detail here; please read it if you're even thinking of trying options as an investment alternative.
What makes LEAPs more interesting than your average call option is their above-average time value. Instead of expiring in a month or a quarter, LEAPs give the patient investor more than a year to wait for catalysts to unlock value.
"Two-and-a-half years is often enough time for many just plain cheap stocks either to be discovered or to regain popularity," writes Joel Greenblatt in You Can Be a Stock Market Genius, still one of my favorite texts for studying more advanced investing topics like LEAPs.
But I didn't need two-and-a-half years. Three months was more than sufficient.
Steve Jobs made me rich
Interestingly, I wasn't buying a super-cheap stock. Apple (Nasdaq: AAPL ) traded at a hefty multiple to earnings in June of 2006, more than I wanted to pay. But I loved the business. Also, at roughly $56 a stub, I suspected that a brutal summer downturn had led Wall Street to sharply underestimate the long-term implications of Apple's partnership with Intel (Nasdaq: INTC ) .
What I needed was a way to compensate for the risks involved with holding a stock that boasted a premium valuation. LEAPs offered the answer. For $8 per share in the contract, I purchased LEAPs with a strike price of $70.
If that seems crazy, it sort of was. The intrinsic value of the option was zero. To break even, the stock would have to be trading for at least $78 at the time of expiration -- the $70 stock price plus my $8 per-share time-value premium. I was counting on shares of Apple rising at least 40% in 18 months, not exactly a no-brainer.
So why did I do it? I set the odds at 50-50, or one chance in two, that Apple could gain at least a point of market share from Dell (Nasdaq: DELL ) and Hewlett-Packard (NYSE: HPQ ) by selling Windows-compatible Macs. I also suspected that, if I was right, the market would reward Apple by pushing its shares close to $100 apiece, at which point I'd own a LEAP worth at least $30 in intrinsic value, nearly four times what I had originally paid for it. The math favored my bet. (A minimum 3.75-to-1 return versus a 1-in-2 chance of a complete loss.)
When I sold the LEAPs at $17.72 apiece -- more than double my purchase price of $8 -- on Oct. 16, 2006, shares of Apple closed at $75.40, above my strike price yet with plenty of time value still remaining. I sold because a scandal over employee stock options pricing was obscuring the risks involved with holding Apple, and thus holding an options position in Apple.
In short: I acted like an equity owner, even if I wasn't one.
Eric Schm ... I mean, I made myself poor
For as many stories like this one, there are plenty of stories of investors losing big with LEAPs and options in general. I'm losing big on my LEAPs in Google (Nasdaq: GOOG ) , which aren't really long-term options anymore. They expire in January of 2010.
I bought in July of 2008 at a strike price of $450 a share -- well below what the stock was trading for at the time -- but without first identifying any short-term catalysts that would lead the shares higher over the 18-month period of the call. As of this writing, my position is down more than 70%.
What I've deduced from this painful buy -- I've lost more on the Google LEAP than I made with my 2006 Apple gain -- is that Greenblatt is only half-right: Buy LEAPs only when you're able to confidently identify and handicap catalysts. (Market-share gains, for example.)
Following this rule has worked for me consistently. For example, when I deduced that the real value of Marvel's (NYSE: MVL ) studio business would become clearer to the Street after the release of 2008's Iron Man, I bought LEAPs to accompany my core position in the shares. Each time, I've emerged a winner.
A final few words of Foolish advice
LEAPs are neither for the faint of heart nor the inattentive. It takes serious study to identify and then handicap catalysts. And yet I've been a net winner with these tools, and Greenblatt -- a master value investor if ever there was one -- endorses them for special situations.
Plus, there will always be opportunities to profit with LEAPs. Consider Microsoft (Nasdaq: MSFT ) . Windows 7 will be out soon, creating a major revenue and profit catalyst for a potentially cheap stock. Why not look at the LEAPs? A January 2011 call option with a $22.50 strike price trades for $3.80 per share as of this writing, according to Yahoo! Finance.
Of course, there are many options when it comes to options, including several lower-risk strategies worth employing. Want a tutorial? Our own Jeff Fischer has produced an exclusive, interactive educational video series on options that's available now. Simply enter your email address in the box below for free access.