How a LEAP of Faith Could Aid Your Portfolio

This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.

For as much as we talk about stocks here at The Motley Fool, the best returns of my investing career have come from long-term call options. Long-term equity anticipation securities, or LEAPS, to be specific.

Here's a closer look at what they are, how to invest in them, and some reasons you might choose them over investing in the stocks they're adjoined to.

Look before you LEAP
All options expire, but LEAPS last longer than most. Contracts can cover 18 months to as long as three years. Extra time means extra opportunity for your investment thesis to pay off.

As with all other stock options, a LEAP grants the owner the right but not the obligation to buy or sell at a specified price by a certain date. Here are two typical LEAPS quotes, taken from Yahoo! Finance with my translations below.

Apple (Nasdaq: AAPL)
Expires at close Friday, Jan. 17, 2014

Source: Yahoo! Finance. *As of Sept. 14, 2011.

Sirius XM Radio (Nasdaq: SIRI)
Expires at close Friday, Jan. 18, 2013

Source: Yahoo! Finance. *As of Sept. 14, 2011.

The strike is the underlying stock price the option owner is guaranteed upon exercise. Thus, one contract for Apple's $410 January 2014 call gives the owner the right but not the obligation to purchase 100 shares of Apple at $410 apiece

The symbol is the options equivalent of a stock ticker symbol. Clicking on any of the links above will take you to a page with many of the details I've provided here. "Last" and "change" should also be familiar terms to most investors. They represent the last quoted price per share for an options contract. The bid and ask represent the per-share prices at which you can sell (i.e., bid) or buy (i.e., ask).

How would the pricing work practically? Let's say you want five contracts for buying 100 shares of Sirius XM Radio at $2 per share on or before Jan. 18, 2013. First, because you're paying for five contracts, your pricing is based on the 500 shares those contracts represent. Multiply 500 by $0.41 per share for the right to buy 500 shares at $2 and you'll pay $205 for the options.

Two primary paths to profit
Investors betting on options profit one of two ways. Either by selling the contract at more than the purchase price, or by exercising and accepting the underlying shares when it's advantageous to do so.

The first strategy is probably obvious. Say shares of Sirius XM rally mightily and the options rise from $0.41 to $1 per contract. Sell, and you'll collect $0.59 a share in profit minus commissions.

The second strategy may not be as obvious. Say Sirius rallies to $3 a share shortly before the options expire, up $1.31 a share from Tuesday's close. You've paid $0.41 to buy shares at $2 apiece, making your potential purchase price $2.41 each for a $3 stock. Exercising gives you an instant $0.59 paper gain and positions you to profit should the business outperform further.

Three strategies for leveraging LEAPS
But again, gains are dependent on something happening within a defined time frame. Why use LEAPS when none of us has a crystal ball? Why make Father Time work against us when it's so easy to put the Old Man to work in our favor? Two reasons:

• Get more reward for the risk. Sirius is a risky stock, and while no one knows whether an improving business will push the stock from $1.69 to $3 before January 2013, wouldn't you rather get a better return if it does happen? The intrinsic value -- i.e., the difference between the strike price and the published price -- of the $2 LEAP from above would rise from zero to $1 a share (i.e., 3-2), more than doubling your investment of $0.41 and significantly outperforming the 78% gain enjoyed by common investors who bought at $1.69 each. (Click here to learn more about how options are priced.)

• Go big without going big. Say you want to have more exposure to Apple than your portfolio would normally allow. Buying one contract for the right to purchase 100 shares of Apple at $390 apiece on or before January 2014 would cost $8,670 going by the ask price listed above. Buying the same number of shares at Tuesday's close would cost more than $38,000.

A multibagger strategy you can try today
Ready to try this for yourself? Good. But first, a word of caution: Options are volatile. And because they operate on a clock, they're prone to expiring worthless. Only money you are prepared to lose should be invested in options.

Now, if you still want to try LEAPS, your best bet may be to look at companies priced well below their one-year price targets. Stocks that analysts believe have tremendous upside over the medium term. Here are two current examples:

• Ford (NYSE: F), which at $10.17 a share on Tuesday traded for a sharp discount to the consensus price target of $18.16. Think Wall Street has it right? Buying a 2013 LEAP at a strike of $12.50 a share costs $1.25 each. The potential upside? A four-bagger, versus the 80% or so for those invested in the common.

• Monster Worldwide (NYSE: MWW), which at $8.36 traded on Tuesday for less than half analysts' one-year target of $17 a share. Buying a 2013 LEAP at a $10 strike costs $1.90 apiece. The potential upside? A 268% gain, versus a double for those invested in the common.

In each case, investing in the LEAPS could be far more profitable than investing in the underlying stock. It won't always be this way, of course. And common stocks are still the best bet for long-term investors. But when it comes to adding a little market-beating muscle to a diversified portfolio, few (ahem) options are as good as LEAPS.

Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments. Click back to the series intro for links to the entire series.