For nearly two years, the financial sector has been rocked by the subprime mess, a credit crunch, hedge fund problems, slowing M&A activity and whatever else we haven’t heard about yet. Sure, the sector has rallied lately, but does anyone believe that it’s all good from here on out?
Sooner or later, the financial sector will come back. (If it doesn’t, then we’ll have bigger problems than just finding profitable opportunities.)
At some point, we can be confident that the sector will bottom out and reverse higher. But it probably won’t happen this month or next. It may not even happen this year. Calling a bottom (or a top) in anything is downright impossible. Anyone who does it once is lucky.
So how do you play the longer term, realizing that you don’t know when the eventual reversal will happen?
You could buy stocks and hold for the long term, but that ties up a lot of cash. And if the sector goes lower, you could be facing steep losses.
The better way to play this is with an exchange-traded fund (ETF) that covers the sector, such as the Financial Select Sector SPDR (XLF).
Or, better yet, you could commit even less cash and play LEAPS.
How LEAPS Work
LEAPS, or Long-term Equity Anticipation Securities, are long-term options, with expirations set up to three years in the future. LEAPS are available into 2011 (2012s will be out starting in September), so you can take a long-term view of a stock and still have the benefits of options, including leverage (more bang for the buck and less cash at risk).
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Now there isn’t anything inherently different about LEAPS compared to shorter-term options. They have puts and calls, have expirations, and trade at similar strike prices. They just have longer expirations.
There are a couple of other differences as well. LEAPS expire in January, so you can currently buy options on, say, Intel (INTC) that expire in January 2011.
Also, LEAPS are not available on all optionable stocks. Around 20%-25% of optionable stocks trade LEAPS, although all the heavily traded stocks have LEAPS. As long as there is demand, the exchanges will create LEAPS, so availability is usually not an issue.
In order to differentiate LEAPS from short-term options, they have a different symbol notation. Normally, LEAPS symbols are based on the underlying stock symbol, and modified by either the letter L, V, W or Z, based on the calendar year. However, due to conflicts with pre-existing security symbols, it is not possible to consistently alter the underlying stock symbol in the same manner for every LEAP expiring in a certain year, nor for each LEAP expiration on a specific underlying stock.
As LEAPS draw closer to expiration (usually within six to nine months), they trade as ordinary shorter-term options and they lose their distinctive LEAPS symbols. In fact, January 2010 LEAPS have been switched over to the regular option symbols. New LEAPS options with expiration dates in the future are added around the time of the switch.
For those who give options a wide berth, LEAPS represent an option that serves as a “best of both worlds” stock substitute. They behave more like a stock than a short-term option, especially with more than a year to expiration. But they retain the benefits of options without some of the negatives, such as the significant impact of time decay.
For more on LEAPS, see:
- Use LEAPS to Avoid Value Traps
- Trading Covered Calls on LEAPS
- Avoid This Simple Mistake When Trading LEAPS
Jon Lewis is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about Jon, read his bio here.
