Using LEAPS Options to Avoid a Value-Trap

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Is it the right time to buy that value stock?

Stock prices start looking more and more attractive the lower they go. It’s like they are going on sale when their prices go down, and we are all suckers for a good sale. In the investment world, we call these sale-priced stocks “value stocks” because they look like they are such a good value. However, sometimes these value stocks don’t turn out to be such a good value after all. All too often, we find stocks that look like a good value that lure us in and then continue to move lower and lower and lower. This is called the “value trap.” These stocks may look like they are a good value, but the stocks that look like a good value today can always look like an even better value tomorrow if they continues to move lower.

[VIDEO] Using LEAPS Options to Avoid a Value-Trap

The question is, how can you tell if a value stock is really just a value trap? Unfortunately, the answer is there is no way of knowing ahead of time. You can certainly conduct a thorough fundamental analysis and assess the momentum of the overall stock market, but you can never know for sure. Investing always involves risk. With that being said, there is a way you can mitigate the risks you face when trading value stocks. You can buy LEAPS calls on them.

LEAPS is an acronym for Long-term Equity AnticiPation Security—in other words, a long-term option. LEAPS are often considered an alternative to stock ownership due to their long-term nature. LEAPS all have the following characteristics:

– LEAPS always expire in January

– LEAPS are American-style options

– LEAPS can have expiration dates as far out as 2 years 8 months in the future

– LEAPS enjoy a slow rate of time decay

Perhaps the most important risk associated with buying options is time decay. The closer an option gets to expiration, the faster the time value begins to decay and the less the option is worth. While LEAPS, like all options, experience time decay, they lose time value much more slowly at the beginning of the contract’s life cycle because the expiration day is so far away. This gives LEAPS buyers an advantage over short-term option buyers. You still get to enjoy all of the leverage associated with options, but you don’t have to worry about all of your time value melting away within the next few months.

Because you don’t have to worry about time decay as much with LEAPS, you can buy and hold them like you would buy and hold a stock.

Avoiding the Value Trap

When you buy a LEAPS call or put, you know exactly how much money you have at risk in the trade. The maximum amount you can lose when you buy an option is the premium you pay for the option. So what does this have to do with avoiding the value trap?

When you buy a value stock and the price declines, you have a decision to make. You can either hold onto the stock and hope it doesn’t go down any further, or you can sell the stock at a loss. This is the trap. When you use a LEAPS contract instead of buying the stock outright, on the other hand, you don’t have to worry about near term declines. You have the luxury to hold onto the LEAPS no matter how far the stock drops in the near term. Since you know you cannot lose anymore than what you paid to buy the LEAPS, you can afford to ride out the near-term volatility and wait for the longer-term trend to emerge.

Using LEAPS Options – Part Two: Why LEAPS are “Under-Priced”

by John Jagerson

One advantage retail traders have, is the fact that long term options are normally underpriced. This happens because there is no way to accurately estimate the probability of a stock’s performance so far in the future and therefore the rare but dramatic unknowns cannot be accurately included in the premium.

For example, there is really no way to estimate the probability of a disruption that a company’s stock price may experience from an SEC investigation or runaway success on a new product. Since these events cannot be anticipated, long term options tend to be cheaper than they should be. That means that options sellers tend to stick with shorter time horizons, while option buyers with a fundamentally bullish outlook on a stock can use with longer term expirations or LEAPs, to capitalize on that natural underpricing.

In the video I will contrast the cost of buying multiple rounds of short term options versus an option with a far away expiration when you have a long term outlook on a stock or index.

Using LEAPS Options – Part Three: A LEAPS Trading Example

by John Jagerson

Walgreens (WAG) released their quarterly report today (June 23, 2008) with some good news. Compared to their industry the 9% increase in revenue and 2% increase in profits is positioning them well for growth once the economy begins to improve. Traders wishing to take advantage of this situation may be interested in a longer term options position.

Too often, options are seen as the domain of the short term trader. This is unfortunate as a longer term options position offers the dual benefits of leverage and fixed risk. In today’s video I will illustrate how a long term options position compares to an outright long position on the stock itself. The risk comparison may surprise you.