Have you ever bought anything used? It could be a car, a house or a $5 blender from a yard sale. They all have something in common:
The old owner usually knows more about what they’re selling than you do.
This phenomenon is known as information asymmetry, a fact that has also long haunted stock investors. Current shareholders (whether insiders or public) often know more about the company than new buyers. And if they are selling shares to us, shouldn’t we be suspicious of why they’re letting go?
But there’s one corner of the market that’s free from this bias: options.
That’s because when we buy options on a stock (i.e., a bet whether the underlying stock will go up or down), we’re not transacting with a fellow shareholder. Instead, we’re buying it from a fully hedged market maker who doesn’t care which direction the stock goes.
Today, we’re going to look at how to use this insight to advantage by using long-dated call options, known as LEAPS.
Rising Stars: LEAPS of Faith
LEAPs, or Long-Term Equity AnticiPation Securities, are long-dated options, often with a year or more until expiration. (If you want to know more about options trading, you can learn from the InvestorPlace.com Options MasterClass here). And in the world of Moonshots, we’re going to focus on call options — the right (but not the obligation) to buy a stock at a specified price.
That’s because LEAPS are unusually cheap for their unlimited upside. Today, you can buy $80 calls Exxon Mobil (NYSE:XOM) calls expiring in 2022 for 32 cents. And if XOM rises back to its pre-pandemic average of $83 before they lapse, the LEAPS would be worth 10x.
The results can be staggering. $10,000 invested in AMC (NYSE:AMC) calls with a $30 August 2021 strike price would have turned into $188,000. If you have above-average insight into a stock, LEAPS are one of the best ways to capitalize on that knowledge.
Ground Rules for LEAPS
- Better Information
Market makers price the average option to earn a small profit. That means the only time we’ll bet is if we have better information than a 50-50 coin flip.
- Out-of-the-Money Only
We’re going to focus on low-cost out-of-the-money options. When your option rises to $5, it helps if you had an entry price of 3 cents rather than $3.
- >2x Potential in the Underlying Asset
Moonshot investing involves finding big winners. That means we want to find companies that are not only cheap but also have the potential to grow 2x to 5x in the next 12 months.
- <100% Implied Volatility
All options have a time decay known as “theta” — the declining premium value the closer an option gets to expiration. To reduce the risk of profits melting away, we’ll focus on contracts with low premiums, as measured by implied volatility (IV).
- Long Only (i.e., Never Short)
We’ll sell options only with a covered position. The income generated isn’t worth the 100% portfolio loss we risk from a bet gone wrong.
Keep in mind that options are risky, and many will go to zero. But those that win can cover losses many times over.
Top LEAPS Trading Ideas
STLA (NYSE:STLA). The Fiat-Chrysler/Peugeot merger created the cheapest legacy automaker on the planet. Momentum is also quite strong, with the stock having risen from $5 in 2020 to $16 today. March 2022 $24 calls are available for 9 cents at the midpoint.
GSAH (NYSE:GSAH). I mentioned Goldman Sachs/Mirion Technologies last week as a SPAC to watch. Now, I’m adding its options to the list. Eagle-eyed investors will realize GSAH has an earn-out clause with equal vesting at $12, $14 and $16. In other words, shares need to rise $2, $4 and $6 for the sponsor to get paid. Investors can buy February 2022 $12.5 calls for around 63 cents, and I’d recommend rolling them forward as longer-dated options become available.
INVZ (NASDAQ:INVZ). InvestorPlace’s Joanna Makris pointed out last month that, at $1.3 billion, Innoviz is one of the cheapest LiDAR companies in the world. With shares down another 6% since then, the SPAC is now trading under its initial $10 valuation. So I’m adding January 2022 $12.5 calls for more conservative investors (and $15 calls for risk-seeking ones). The option midpoints are 50 cents and 25 cents, respectively.
PSTH (NYSE:PSTH). Bill Ackman’s SPAC fell double-digits Monday after announcing its withdrawal from the Universal Music deal. The stock now trades at $20.5, virtually at its $20 cash value. Buying a $22.5 call for Jan 2022 at 60 cents is a no-brainer — the experienced dealmaker has a history of surprising his doubters.
Falling to Earth: Is Dogecoin Dead? Lessons from Momentum Investing
When I published my top alt-Dogecoin list last month, I told investors to consider five of my top picks. Those who bought would have seen a 1,000% return in three weeks.
Meanwhile, the three cryptos I suggested to avoid? Those dropped by an average of -20%.
How did that happen?
As expected, momentum dominated the conversation. No matter how correlated these cryptocurrencies are to Tesla (NASDAQ:TSLA) or any other risk-on asset. If prices aren’t going up, crypto speculators aren’t interested.
Today, the same is still valid for Dogecoin (CCC:DOGE-USD), the cryptocurrency I once recommended at $0.03 (and again at $0.14 before it jumped to $0.70). Though prices are back below $0.20, I’m not tempted to buy in quite yet. With momentum on the decline, it’s better to enjoy the summer before jumping back in.
In addition, I am now removing all five alt-Dogecoin picks from my “buy” list. With the momentum of these five tokens starting to wane, it’s time to take profit on the 1,000% returns and come back another time.
By the Numbers: With Cryptocurrencies, Popularity Isn’t Everything
|$4.6 billion||Dollar amount lost by SafeMoon (CCC:SAFEMOON-USD) investors since the token peaked last May.|
|2.4 million||The number of SafeMoon holder addresses, 1 million higher than during its price peak.|
|$52 million||Liquidation by a single initial SafeMoon address since May. Insider sales of tokens have accelerated in recent weeks as MOON prices have sagged.|
|97%||Percent of code BabyDogeCoin (CCC:BABYDOGE-USD) shares with SafeMoon. The new token has risen 820% since inception, while its parent token has dropped 25%.|
Closing Thoughts: The Value Proposition of LEAPS
Years ago, one of my good friends worked at the New York Stock Exchange as an options market maker. And like most of his co-workers, he knew virtually nothing about stocks.
Instead, his job was to quote options prices and to keep a neutral position. He was only there to help the NYSE offer pools of liquidity to stay competitive against the NASDAQ exchange.
That makes options one of the best ways to capitalize on our knowledge. The NYSE doesn’t care if you earn $100,000 on a winning LEAPS bid — they would have delta hedged their exposure long before losing a single penny. Nor do they celebrate if an investor loses the same amount; hedging losses offset any gain.
For those who haven’t learned how to trade options yet, I really suggest InvestorPlace’s Options Masterclass. (Again, you can sign up for a course here). Knowing the basics can help you save thousands of dollars while maximizing your chances at triple-digit returns.
And if you’ve already taken the Masterclass, then great! I look forward to continuing sharing my top tips from today’s fast-moving markets.
Questions or comments? Connect with Tom on LinkedIn.
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.