Making LEAPS Toward Profit

 | Mar 25, 2014 | 1:30 PM EDT
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The essence of investing is putting money into places where the probability of a gain far outweighs the risk of a loss. In other words, what you never want from investing is pure speculation, which is akin to nothing more than a coin flip.

Stock options, while very speculative in nature, can at times offer the skewed probability of a significant gain compared with the risk assumed. One favorite of mine is long-term equity anticipation securities, commonly known as LEAPS, a long-term option usually with an expiry of two years or more. Because options move very quickly in relation to the underlying stock price, owning LEAPS allows for a greater window of opportunity to cash in. Since a major component of options pricing has to do with the length of option, owning LEAPS costs more. Therefore, LEAPS are a very desirable to own against a security with significant upside potential. Such stocks are often already in trouble today. However, by owning LEAPS, you reduce the capital outlay otherwise required to own the stock.

An intriguing candidate is J.C. Penny (JCP). The shares were recently trading around $8.60, up more than 70% since falling to $5 per share in February. Anyone who owned LEAPS at the time is probably enjoying a 100%-plus gain today. Even so, J.C. Penny is still restructuring. If successful, the stock is likely worth close to $20 in a couple of years. Today you can purchase the January 2016 $15 call option for approximately $0.95. If by January 15, 2016, shares are trading above $15.95, you will break even at worst. If shares are trading at $20, your option will be worth $5, a fivefold return on investment from owning the leap vs. getting back just over double by holding the stock.

Weight Watchers (WTW) is another ripe candidate for LEAPS. Owning shares in WTW has been a painful exercise the past year. Trading at $19.66 recently, shares are at the same price as during the financial crisis. After climbing as high as $80 per share, the shares have been pummeled as operating performance has deteriorated. Two billion dollars worth of debt on the balance sheet is not encouraging, but the company generates ample free cash flow, or at least it did until the most recent quarter. Over the past three years, free cash flow has averaged nearly $300 million per year, and the company today has a market cap of $1.1 billion and an enterprise value of $3.3 billion. In the fourth quarter of 2013, net income dove and free cash flow came in at $18 million.

WTW shares are priced for doom, but the slightest trickle of a turnaround will send shares surging higher. You can buy the January 2016 $30 call option for $2.25. If in two years, with a breakeven price of $32.25 (I ignore commissions for simplicity), shares touch $40, the options are worth $10 -- more than quadruple today's price against doubling the return on holding the stock. If you want to dream a little and imagine that shares get back to $80, those LEAPs are worth $50. That's a return of 2,300%.

Clearly, the elasticity of potential returns make LEAPS an intriguing bet. The key is to have a story behind why a security has the potential to advance significantly higher.

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