Using LEAPS to Invest In China

Editor's Note: You can find our complete library of free investing articles here.

Across the globe stock markets are significantly correlated. They tend to go up and down together at the same time. If U.S. stocks are rising then international stocks tend to follow but they may not run at the same pace. However, stocks in emerging economies typically grow in value far faster than U.S. or Western European stock markets during good economic times. For example, in 2009 some Chinese stock funds nearly doubled the returns of the S&P 500.

[VIDEO] Using LEAPs to Invest in China

If economic growth continues to improve in 2010 and 2011 these funds could double the performance of U.S. stocks again. Having an investment in an emerging market, like China, can turbocharge your portfolio but it does come with risks. To offset some of these risks, some investors are even opting for longer term options to take advantage of the potential for Chinese growth. An option trade like that requires a much smaller investment on a per-share basis but the return percentage can be much higher if everything goes well.

Amongst emerging market funds, those concentrating on the “BRIC” economies are the most popular. BRIC stands for Brazil, Russia, India and China. Sometimes an emerging market fund may also supplement BRIC investments with stocks from places like Turkey, Mexico and South Africa.

Just as we might expect small cap stocks to outperform large cap stocks in a bull market, the growth potential is higher in emerging markets than within larger more established economies like the U.S., U.K. or Western Europe.

Greater risks almost always accompany greater profit opportunities. For example, during the 2007-2008 U.S. stock market crash the S&P 500 was down 60% but Chinese stock ETFs were down 73%.

However, keep in mind that the increased volatility in international stocks is bad on the way down but can be a big benefit on the way up. The potential upside is what attracts investors to international stocks like this and long term options may be one way to avoid the value trap when prices decline suddenly.

A value trap happens when share prices are dropping quickly and traders are faced with the dilemma of holding the shares and hoping prices come back or selling the shares and recognizing the loss. A value trap is powerful because often traders don’t know what their maximum loss could be.

If an ETF costs $100 per share they could theoretically lose a maximum of $100 if prices collapse. Alternatively, an option buyer knows that the maximum loss in a trade is the premium paid for the option. In absolute dollar terms this is usually much smaller than a stock purchase.

Long term investors will often utilize LEAPs calls for this kind of play. If the market rises they will make a higher percentage profit than an investor holding the stock and they have a lower maximum loss in dollar terms to the downside. This combination of benefits can be a nice fit for traders evaluating a volatile position like emerging market stocks.

Imagine that you are evaluating a long position on FXI, which is an exchange traded fund that invests in Chinese stocks. The shares are available for $41.16 and you believe the stock will rise another $20 over the next year and a half. You could buy the stock or potentially invest in a LEAP call for the same reason. If you select the LEAPS option, the at the money strike is $40 and a call that expires in 18 months costs $8.20 per share or $820 per contract.

Potential Outcome #1: Stock rises $20 to $61.16 in 18 months.

  • LEAP call is worth $21.16 per share for a 158% gain
  • Stock is worth $61.16 for a 50% gain

Potential Outcome #2: Stock falls to $20 in 18 months.

  • LEAP call is worth nothing for a max loss of $8.20
  • Stock is worth $20 for a loss of $21.16

The example above is a little biased because if the stock remains flat the stock buyer will outperform the options trader who may still lose their entire investment if the market stays below $40. However, an investor may consider historical volatility as an indication that this outcome is unlikely.

Like all investing decisions, ultimately it comes down to the investor’s ability to forecast market direction. An option’s investment may be a great alternative for volatile stocks and a long term LEAP contract is a great way to make sure there is plenty of time for an ETF like this to move.