We all know options can be a great way to generate income, as I’ve written about before. We also know options can be a useful tool to hedge your long stock positions. There’s another great play that uses options that I reserve for very speculative situations, including one that I’m facing right now. That’s when I like to use LEAPS (or, longer-term options).
One of the tricks with options is that you may make a correct call on a stock price’s movement, but have the time frame wrong. By using a longer-term option (through which you can get up to an additional two years’ worth of time with your position), you can protect against that mistake.
Of course, since options are priced according to time frame, it means this alternative will be more costly. That’s why I only go for it in highly speculative situations where my risk in using just a straight stock purchase or shorting is unlimited. With LEAPS, I can easily limit that risk.
The best way to illustrate the use of LEAPS is to use a real example — a situation that is in play right now. It involves Netflix (NASDAQ:NFLX).
There’s been a lot of speculation as to whether Netflix is going to survive and thrive … or struggle but survive … or die quickly … or even die slowly.
The easy money has been made — if you shorted when the stock was in the $200s or even the $100s, you’ve done well. But how do we play it from here?
My own opinion is that Netflix is going to go bankrupt, and it is likely to happen in the next two years. The problem is that, in the interim, the stock may jump from the $60s, where it is now, to over $100. Who knows?
I could short it and set a stop-loss, but if the stock should gap up on the open, it’ll blow through my stop-loss.
I want a situation where I don’t have to risk as much as I might shorting the stock, but which bets on a complete implosion. So far, Netflix has shown a tendency to drop by double-digits on days with bad news. I think that’s going to continue.
So, I’m looking at buying the NFLX January (2013) 65 Puts, which are selling for $20 per share, or about $2,000 per contract. That means if Netflix craters to $45 by then, I will break even.
In fact, if it does so before January 2013, I may even be able to sell it for more than $20, given the time value of the option that remains. And if NFLX should totally implode and go to zero, the put will be worth $65, and I will more than triple my money.
That’s one way to play it. But an even-better choice is the January (2014) 65 Puts, which are selling for about $25. With the 2014 expiration, I get an extra year on my option for only $500 more.
I break even if the stock hits $40 on expiration, and maybe make something if it does so before expiration. Once again, if the stock goes to zero, I will make $65 for the contract, and more than double my money.
You can, of course, buy calls that are way out-of-the-money (that is, with strike prices that are higher than the market price of the shares) on stocks you think might go much, much higher without risking the capital to buy the stock. Again, though, save these LEAPS for very speculative situations.
Lawrence Meyers does not currently have any positions in NFLX.