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 your portfolio should take 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. Motley Fool Options advisor Jim Gillies does an excellent job of explaining this concept in detail here; please read it if you're 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.
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 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 highly successful partnership with Intel.
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 slam-dunk.
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 PC peers by selling Windows-compatible Macs. I also suspected that, if I were 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, a near four-bagger. The math favored my bet. (A minimum 3.75-to-1 return versus a 1-in-2 chance of a complete loss.)
Gaming investors might recognize this math. Wynn Resorts (Nasdaq: WYNN ) , Melco Crown Entertainment (Nasdaq: MPEL ) , and their peers profit by exploiting the mathematical edges built into their casino games. It's usually enough to service billions in construction debt. My edge was less certain, but I liked my chances to profit.
When I sold the LEAPs at $17.72 apiece -- more than double my purchase price of $8 -- on October 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 more stories of investors losing big with LEAPs and options in general. I lost big on 2010 LEAPs in Google.
I bought in July 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. I sold in November, realizing a 30% loss.
In hindsight, I shouldn't be surprised. Catalysts often precede returns. When Netflix (Nasdaq: NFLX ) brokered a deal with Starz in 2008 to stream movies the company was showing on cable, it helped boost demand for its Watch Instantly streaming service. Profitable changes to its business model followed, and the stock is up seven-fold since.
Shares of Acme Packet (Nasdaq: APKT ) have more than quadrupled as more businesses and consumers have taken to the Internet for communications. Voice over IP, in particular. (Acme Packet's gear helps connects disparate networks so that the Internet acts more like the aged analog phone network we've relied upon for decades.)
Catalysts matter, and I've done well when I've paid attention to them. For example, when I deduced that the real value of Marvel's studio business would become clear to the Street after the release of 2008's Iron Man, I bought LEAPs to accompany my core position in the shares. Each purchase was 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 Sirius XM Radio (Nasdaq: SIRI ) . Cash is flowing, and the valuation has gone reasonable compared to historical standards. So long as demand for Sirius' content continues -- and with its subscriber count at 20 million and rising, that appears to be the case -- the underlying business should see continued gains. Why not look at the LEAPs? A January 2013 call option with a $1.50 strike price trades for $0.48 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. Care to learn more? Enter your email address in the box below to find out more about our Motley Fool Options service.