This article originally appeared on the Learning Markets Web site.
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 they 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 today, but they can always look like an even better value tomorrow if they continues to move lower.
So, 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
LEAPS 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 hold on to 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 on to the LEAPS no matter how far the stock drops in the near term.
Since you know you can’t lose any more 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.