LEAPS Investment: Preventing Losses with a Fixed Price

This article is an excerpt from the Shortform book guide to "You Can Be a Stock Market Genius" by Joel Greenblatt. Shortform has the world's best summaries and analyses of books you should be reading.

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What are long-term equity anticipation securities (LEAPS)? How can a LEAPS investment help you prevent losses?

A LEAPS investment is a strategy involving calls, or financial contracts, with a company that guarantees you the right to buy stock at a fixed price in the future. LEAPS are a way to make a profit from leveraged companies with minimal risk.

Learn more about a LEAPS investment and how you can use this strategy to make a profit.

Understanding LEAPS Investment

In this article, we’ll discuss why long-term equity anticipation securities (LEAPS) are wise investments when a company is leveraged. Stub stocks, Greenblatt points out, are a relatively rare phenomenon. However, he writes that you can enjoy similar benefits to stub stocks by investing in long-term equity anticipation securities (LEAPS).

How to Profit From a LEAPS Investment

According to Greenblatt, LEAPS are another investment vehicle that can yield outsized returns while minimizing downside risk.

First, Greenblatt clarifies that LEAPS are a type of call—a financial contract that gives its owner the right (but not the obligation) to purchase a security at a guaranteed price in the future. For example, if at the start of 2023 you believed Disney’s stock would rise from its price of $90, then you could purchase a call for (say) $1 to purchase a share of Disney stock at $90 anytime before April. If your prediction panned out, you could exercise your option to buy Disney stock at $90, sell it at its increased price, and profit handsomely. The only distinction between LEAPS and general calls is the time horizon—LEAPS provide you with the right to purchase a stock at a fixed price up to two and a half years in the future, whereas normal calls have shorter timeframes.

(Shortform note: Calls, such as LEAPS, are one of two types of options, the other type being puts. Whereas calls give their owners the right to buy a security at a guaranteed price, puts give their owners the right to sell a security at a guaranteed price. Investors who purchase puts believe a security’s price will drop before the put expires. For instance, if you purchased a put giving you the right to sell one share of Meta stock at $300 by the end of the month and Meta’s share price dropped to $250, you could earn $50 by purchasing Meta at $250 and exercising your right to sell it at $300.)

Like stub stocks, LEAPS can amplify increases in stock price to yield disproportionately large returns. Returning to the previous example, if you purchased 1,000 LEAPS at $1 each that gave you the right to buy Disney at $90 down the line, then you could earn $10 per LEAP if Disney stock rose to $100 per share. Thus, your initial $1,000 investment would return $10,000, a tenfold increase. By contrast, those who owned Disney’s common stock at $90 would earn a meager 11% return on investment in the same period.

Greenblatt also points out that a LEAPS investment drastically limits your potential loss. For example, imagine that in the previous example, Disney stock instead crashed to $50 per share. Disney’s shareholders would therefore lose $40 per share, while you would only be out the $1 cost per LEAP. In other words, you lose no more money if Disney stock drops from $90 to $88 per share than if it drops from $90 to $50 per share. LEAPS thus provide better downside protection than owning common stock.

The Potential Downsides of a LEAPS Investment
Greenblatt offers an unambiguously positive portrayal of a LEAPS investment, according to which they not only deliver greater returns but also minimize risk. However, other experts caution that LEAPS have an array of disadvantages that Greenblatt doesn’t mention. For example:

1. LEAPS are consistently more expensive than short-term calls with the same strike price (the price at which you have the right to purchase shares), meaning you’re risking more money than you would by purchasing short-term calls.
2. LEAPS are sometimes unavailable for stocks you wish to invest in, meaning you have fewer options to invest in them.
3. LEAPS can lead to much larger percentage losses than owning the underlying stock, because you lose your entire investment if the stock doesn’t surpass the strike price, whereas owners of the common stock lose only a portion of their investment.
4. LEAPS deprive you of benefits afforded to common stock owners, such as dividend payments and voting rights.

For these reasons, a LEAPS investment isn’t a magic bullet, even if it can deliver outsized returns in the right circumstances.

LEAPS Investment: Preventing Losses with a Fixed Price