What Are LEAP Options and How to Double Leverage Them

What Are LEAP Options: Maximize Their Potential with Double Leverage

June 14, 2024

The Double Play Strategy: Using Puts to Reduce Risk and LEAPS to Amplify Returns

In investing, the interplay between risk and reward is a delicate balance that investors must master to achieve long-term success. Investors constantly seek strategies to help them navigate market volatility, manage risk, and maximize returns. One intriguing and sophisticated strategy that leverages options to reduce risk and amplify returns is the “Double Play.”

The Double Play strategy is designed to provide a dual advantage: generating income and enhancing growth potential. This approach involves selling options on stocks you don’t mind owning, particularly after a market crash when valuations are more attractive. By doing so, investors collect premiums that act as an immediate income stream. The real genius of the Double Play strategy lies in how these premiums are utilized: they are reinvested to purchase long-term call options, known as LEAPS (Long-Term Equity Anticipation Securities), on high-quality stocks with significant growth prospects.

This combination provides a safety net by potentially acquiring desired stocks at a lower cost and positions investors to capitalize on significant market upswings through leveraged exposure to long-term growth opportunities. The Double Play strategy exemplifies the intelligent use of options to balance risk and reward, demonstrating a sophisticated yet practical approach to achieving financial success.

The Mechanics of the Double Play Strategy:

Selling Puts on Desired Stocks: Selling put options involves selling the right to another investor to sell you a stock at a predetermined price (strike price) by a specific date. You can generate income from the premiums by selling puts on stocks you wouldn’t mind owning, especially after a market crash or significant pullback. If the stock price falls below the strike price, you may be obligated to purchase the stock at a discount, which is acceptable since you have already identified it as a desirable investment.

Example:

Suppose you want to own shares of Company XYZ, a fundamentally strong tech company. After a market correction, XYZ’s stock price drops to $100. You sell a put option with a strike price of $95, expiring in three months, and receive a premium of $5 per share. You keep the premium if XYZ’s stock price remains above $95. If it falls below $95, you buy the stock at an effective price of $90 (strike price minus premium), which you were comfortable with initially.

Using Premiums to Purchase LEAPS:

LEAPS (Long-Term Equity Anticipation Securities) are call options with expiration dates typically extending over one year. They provide the right to buy a stock at a specified price within a longer timeframe, allowing you to benefit from potential long-term appreciation. Using the premiums obtained from selling puts, you can purchase LEAPS on high-quality stocks with solid growth potential.

Example:

Continuing the previous example, you use the $5 per share premium from selling the XYZ put options to buy LEAPS on Company ABC, another promising tech stock. ABC’s stock is currently trading at $120, and you purchase LEAPS with a strike price of $130, expiring in two years. If ABC’s stock price rises to $180 within that period, your LEAPS would be worth significantly more, providing substantial returns.

Benefits of the Double Play Strategy:

1. Income Generation:

Selling puts generates immediate income through premiums, which can be reinvested or used to purchase other assets like LEAPS. This income can enhance overall portfolio returns, even if the puts are not exercised.

2. Risk Mitigation:

By selling puts on stocks you are willing to own, you create a built-in margin of safety. If the market declines, you acquire stocks at a lower cost basis, reducing the potential downside.

3. Leveraged Upside Potential:

LEAPS allow you to leverage your investment in high-quality stocks with significant growth potential. If the underlying stock appreciates, the value of your LEAPS can increase substantially, providing amplified returns.

4. Flexibility and Long-Term Focus:

The Double Play strategy aligns with a long-term investment horizon. It allows you to benefit from market corrections by acquiring desirable stocks at lower prices while positioning yourself for future growth through LEAPS.

Citing Historical Examples

1. The 2008 Financial Crisis:

During the 2008 financial crisis, many high-quality stocks experienced significant declines. Investors who sold puts on fundamentally strong companies like Apple (AAPL) or Microsoft (MSFT) and used the premiums to purchase LEAPS on these stocks would have benefited immensely from the subsequent market recovery. Apple’s stock price, for instance, surged from around $90 in early 2009 to over $500 by 2012, providing substantial returns for those who held LEAPS.

2. The COVID-19 Market Crash:

The COVID-19 pandemic triggered a sharp market decline in early 2020. Savvy investors who sold puts on resilient companies like Amazon (AMZN) or Alphabet (GOOGL) and used the premiums to buy LEAPS on these stocks witnessed remarkable gains as the market rebounded. Amazon’s stock price, for example, soared from around $1,600 in March 2020 to over $3,300 by the end of 2020, delivering significant profits to LEAPS holders.

Conclusion: Embracing the Double Play Strategy for Financial Success

The Double Play strategy exemplifies how options can be used creatively to balance risk and reward. By selling puts on desired stocks after a market crash and using the premiums to purchase LEAPS on high-quality growth stocks, investors can generate income, mitigate risk, and position themselves for substantial long-term gains.

This approach leverages common sense and practical wisdom, demonstrating the power of combining traditional investment principles with innovative strategies to achieve financial success. Notable financial experts and successful investors have long advocated for the principles underlying this strategy:

Warren Buffett: The Oracle of Omaha has famously advised investors to be “fearful when others are greedy and greedy when others are fearful.” This contrarian mindset is at the heart of the Double Play strategy, where investors capitalize on market fear by selling puts and buying LEAPS during undervalued periods.

Benjamin Graham: Known as the father of value investing, Graham emphasized the importance of a margin of safety. Selling puts on stocks you are comfortable owning at a lower price, which aligns with Graham’s philosophy, providing a built-in safety net and potential for acquiring undervalued assets.

Peter Lynch: Renowned for his successful tenure at the Fidelity Magellan Fund, Lynch believed in investing in what you know and maintaining a long-term perspective. The Double Play strategy aligns with his approach by focusing on high-quality growth stocks and allowing time for their potential to unfold through LEAPS.

John C. Bogle: The founder of Vanguard Group and a pioneer of index investing, Bogle stressed the importance of staying the course and minimizing costs. By generating income through selling puts and strategically reinvesting premiums in LEAPS, investors can enhance their returns while keeping costs relatively low.

The Double Play strategy is not just a theoretical concept but a practical application of timeless investment wisdom. It allows investors to take advantage of market volatility, generate consistent income, and position themselves for significant appreciation in high-quality stocks. By understanding and implementing this strategy, investors can navigate the complex landscape of risk and reward with greater confidence and achieve lasting financial success.

Ultimately, the Double Play strategy underscores the importance of being smart and strategic in investment decisions. It is a testament to the enduring relevance of common sense in finance, where careful planning, disciplined execution, and a willingness to embrace innovative approaches can pave the way for extraordinary outcomes.