There are more famous value investors than Joel Greenblatt, but you might be hard-pressed to find one more conservative. Well-known for concentrating bets on very cheap stocks, Greenblatt has also made waves for proving that it isn't terribly difficult to find stocks that trade at a sharp discount to fair value.
You'd think a guy like that would never touch stock options, where every bet is either in the money or out of the money. Win big or lose everything. Too much for a dyed-in-the-wool value hound, right? Right?! Wrong.
Greenblatt was first to introduce me to long-term equity anticipation securities, or LEAPS, in his breakthrough book, You Can Be a Stock Market Genius. Some of the very best returns of my investing career have come from buying to hold these types of options.
So in the spirit of Leap Day -- it only comes once every four years, people -- here's a closer look at what LEAPS are, how to invest in them, and some reasons why you might choose them over investing in the stocks they're adjoined to.
Fun and profit with options!
If you've never invested with stock options before, they differ from stocks in two primary ways:
- There's no ownership interest. Options represent the right, but not the obligation, to purchase or sell a set amount of stock at a predetermined price. Options are sold via contracts that carry a premium -- i.e., a fee -- to open and close. Each contract represents potential ownership in 100 shares of the attached stock.
- They're limited. All options expire at some point. Short-term options may last a few days or even a month. LEAPS, by contrast, can last from 18 months to three years.
Pricing options depends principally on two variables: time and value. The "time premium" refers to the cost of locking in an exercisable price over a predetermined period. The shorter the period, the lower the time premium. LEAPS have a higher time premium because they're valid longer.
Options also have an "intrinsic value," defined as the difference between the "strike" and present value per share. Thus, if you own an option for a stock trading at $20 per share with a strike price of $18, you're sitting on $2 a share of intrinsic options value. Make sense? Good. Now let's get practical.
Pricing your options
Option investors make money when the underlying stock rises above (i.e., a "call" option) or falls below (i.e., a "put" option) the predetermined price, or strike, at which the contract was purchased. LEAPS are typically calls bought in anticipation of some sort of catalyst driving the underlying stock price higher before the option expires.
Say you believe that Green Mountain Coffee Roasters' (Nasdaq: GMCR ) new Vue brewer will be a hit, lifting revenue and profits higher than the Street expects. News either confirming or debunking that theory should come within a quarter or two. Buying LEAPS expiring in January 2014 should allow for catalysts to develop while leaving plenty of time for delays or other unexpected hiccups.
Let's take this a step further and walk through a transaction involving LEAPS. Assuming you believe that Green Mountain will outperform analyst targets and rise above their $89-a-share one-year price target within two years, you could purchase a contract designed to maximize profit if you're right. One possibility: buy LEAPS with a $65 strike -- roughly equivalent to today's quote -- for $20 a share. You'll need the stock to rise to $85 a share just to break even, but at $105 you'd be sitting on a double on intrinsic value alone. ($105 - $65 = $40 per share in intrinsic options value, versus the $20 per share contract premium.)
Or you could exercise the option. By that I mean exercising your right to purchase Green Mountain shares as the LEAPS owner. You'd purchase 100 shares of Green Mountain for every open contract you own, but at the predetermined price of $65 a share. Even after accounting for the $20-per-share options premium you paid up front, that's still a hefty profit if the stock has risen to $105 a share as you expected, and you'll be positioned to profit further if outrageous growth continues.
And that's just a teaser for what's possible with LEAPS specifically and options generally. Click here to read a full primer on how options are priced, bought, and sold.
Two ideas you can try right now
If at this point you're still feeling bold enough to try LEAPS -- knowing that with options, 100% losses can and often happen -- here are two companies priced well below Wall Street's average one-year price targets. If they hit, they'll hit very big for LEAPS holders:
- Car renter Avis Budget (Nasdaq: CAR ) closed yesterday's trading at $12.92 a share, well off the Street's $20.79 price target. A January 2014 LEAPS with a strike of $12 a share costs $3.70 apiece. The potential upside if analysts are right? A double, versus a 61% gain for those holding common shares.
- Wireless provider NII Holdings (Nasdaq: NIHD ) closed at $18.95 a share, a sharp discount to the $30.73 price target analysts have set. A January 2014 LEAPS with a strike of $20 costs $4.70 a share as of this writing. The potential upside? Another double, versus a 62% gain for those holding the common.
Avis Budget looks promising in part because rival Hertz (NYSE: HTZ ) still wants to copy its strategy of offering both low-cost and premium service. How do we know? Hints of renewed pursuit of a deal with cut-rate renter Dollar Thrifty resurfaced this month. And while NII Holdings took a beating for failing to meet Street estimates when reporting fourth-quarter earnings last week, the company remains one of the best-positioned providers of wireless services to Latin American customers, and the stock trades about in line with Wall Street's long-term estimates for profit growth. Any upside surprise should kick off a nice rally.
Yet LEAPS holders would profit more than most in either case because of the unusually attractive pricing of their options.
Does that mean you should stick with LEAPS and avoid stocks? Hardly. LEAPS may be a great tool, but they aren't the only (ahem) option for earning multibagger returns. Rule Breakers work just as well. What's a Rule Breaker, and how can buying one change your fortunes? Find out in a new Motley Fool special report titled "Discover the Next Rule-Breaking Multibagger." The research is free, but only for a limited time, so click here to get your copy now.