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A Double in 3 Months

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.

Fool contributor Tim Beyers had stock and options positions in Apple, Google, and Marvel at the time of publication. Apple and Marvel are Stock Advisor selections. Dell, Intel, and Microsoft are Inside Value picks. Google is a Rule Breakers recommendation. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 17, 2009, at 6:17 PM, YingandYang wrote:

    DOE to announce winners on / or before "Labor Day

    VRNM was 1st invited in and 1st with completed pkg., with all DD for DOE

  • Report this Comment On August 17, 2009, at 6:21 PM, YingandYang wrote:

    Andy Obermueller Editor, Government-Driven Investing-I like Verenium. I personally hold shares 3-Aug-09 02:42 pm Andy Obermueller Editor, Government-Driven Investing-I like Verenium. I personally hold shares

    Sent: Monday, August 03, 2009 10:36 AM

    I like Verenium. I personally hold shares and I I have recommended them in my Government-Driven Investing portfolio. They are a long-term hold. The Florida project will mean good things.

    Thanks , for reading. Many happy returns.

    Andy Obermueller

    Finally, No More Guessing

    Investing is tough enough in good times. In this shell-shocked economy, you need an edge that puts the odds squarely on your side. The best way to do that today... indeed the only way... is to limit your investments to those that are virtually guaranteed to succeed -- thanks to the daunting power of the federal government.

  • Report this Comment On August 17, 2009, at 6:28 PM, YingandYang wrote:

    DOE goal is to award 70% of the funds by Labor Day 13-Aug-09 04:20 pm Since mid-February, $26 billion of the nearly $100 billion in stimulus funds for energy has been authorized for clean energy projects, according to Chu. He said the DOE’s goal is to award 70% of the funds by Labor Day.

    Sentiment : Strong Buy

  • Report this Comment On August 17, 2009, at 7:42 PM, Scaooba wrote:

    "Consider Microsoft (Nasdaq: MSFT). Windows 7 will be out soon, creating a major revenue and profit catalyst for a potentially cheap stock."

    Not sure about that, I won't be buying Win7 until they pry XP out of my cold dead hands or until can't play Half-Life and L4D anymore on XP. Which ever comes first. Seriously, not planning on buying it and doubt if they are going to install it on my work laptop either.

    Except for games and Google SketchUp I use Linux at home. I don't know anyone else planning or even talking about Win7 either, except on the internet sometimes.

  • Report this Comment On August 17, 2009, at 10:45 PM, khanazul wrote:

    Scaooba, first let me say that I, while not a Linux user, will also be clinging to XP until the Microsoft Secret Service comes and personally formats my hard drive.

    That said, bear three things in mind:

    1) windows 7 will be installed on every new PC and MS-based laptop sold.

    2) there is always the population of those who just gotta have the new stuff because it's,

    3) for some software developers, it will be professionally necessary to become familiar with the OS.

    4) (Ok, I lied) then there are those who are hoping that 7 "fixes" Vista.

    Don't expect businesses to make the leap until a service pack comes out. Another good time to own :)

    So, will you or I own it? Not until we have to. Will it sell? Like chocolate at a women's convention.

    See you on L4D!

  • Report this Comment On August 31, 2009, at 9:43 AM, demus24 wrote:

    Why not just but and hold. If you still held apple you would be making a killing in the next 5 years not 3 months. Fools indeed.

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