How LEAP Trades can Double Your Profits at a Quarter of the Cost
I got a call from a friend last week with a very specific question.
“Hey CJ, I saw what happened with NVIDIA stock after earnings and I need to buy some of these shares. Do you think it’s worth dropping $40,000 on 100 shares of the stock for my portfolio?”
The concern that he had is one that most investors share when looking at a stock with a high price tag.
It’s a situation that a lot of investors run into as stock prices like Nvidia Corporation (NVDA) soar into that stratosphere of higher-priced stock.
To give you an idea, there are about 100 optionable stocks that trade above $300 currently in the market.
Names like Autozone Inc (AZO), Costco Wholesale Corporation (COST), Deere & Co (DE), and Home Depot Inc (HD) are among those stocks that require a hefty investment in order to buy 100 shares for a portfolio.
There’s a strategy that I’ve used for a long time that allows me to build long-term portfolios of stocks that I want to own in a way that can lower the amount invested in each position, I refer to it as a synthetic stock portfolio.
How do I synthesize stock holdings?
Simple, I use LEAPs.
LEAPS (Long-Term Equity Anticipation Securities) are offered as both calls and puts and can be traded on a large swath of the optionable stock universe. They offer the same advantages of shorter-term call options in terms of leveraging moves – both higher or lower – on a stock, ETF, or index.
Why do I like them in this situation? Well, as a long-term bull on NVDA, I would like to add the stock to my portfolio. Of course, the $388 price tag per share would take a bite out of my portfolio’s cash if I were to buy 100 shares. Why do I keep talking about buying 100 shares? We’ll get to that in a minute.
First, how I set up my synthetic trade using LEAPs.
I’m looking to buy a lot of time, so the January 17, 2025 call options are the expiration I’m going with.
Next, I have to determine which strike price that I want to use for this synthetic stock position. Normally, I will select a strike that it is out of the money with a technical feature that may help to accelerate the price when crossed.
In this case, the $420 strike stands out:
This was the most recent high for NVDA shares. It’s about 6% out of the money, so I will be saving a little on a premium over the at-the-money $395 LEAP CALLS.
The technical feature of this price having been the recent highs indicates that there is a chance we will see an acceleration in the price moving higher when we break above that price.
This also means that my $420 option will benefit from that and the convexity of the option going in the money at the same time.
Here’s the comparison of the purchase of 100 shares of NVDA versus 1 January 17, 2025 NVDA $420 Call.
So you’ll notice right out of the gate, the difference in cost between these two transactions. The LEAP that I am investing in – note that I said investing in, not trading – is only 23% of the cost of purchasing 100 shares of the stock, but that one contract also controls 100 shares. So, for less than 25% of the share price, I can have control over those same 100 shares.
Let’s look down the road and see what this trade might look like if the stock moves higher by the end of 2023.
Let’s say that shares of NVDA are trading at $490 on December 31, 2023. Here’s how the stock and the synthetic stock positions would look.
As you can see, the leveraged nature of the LEAP and the convexity that I mentioned are playing out to provide a return of 53% for the LEAP option that I used to synthesize the stock, while the stock purchase has returned 23% to this point.
There’s a kicker though.
When the LEAP option goes in the money I can choose to start writing covered calls on it to generate a little extra income. Remember, this is not a speculative call option “trade” for me, this is a synthetic stock investment so I will choose to generate income on this position with that covered call strategy (for the sake of brevity, I’ll go into this in more detail another day).
Moving forward to July, 2024 and assuming that the stock grows another 25% over that six months (a relatively conservative target given NVDA’s trend and fundamental outlook) here’s what the positions would look like.
Finally, if we play this all the way out to the end of Expiration (January 17, 2025) and assume yet another 25% growth in the stock….
Here are the obvious negatives.
First, the stock is obviously going to have some periods in which it trades lower. This will affect the value of the option as much or more than the value of the stock position depending on how deep in, or out of the money the option is.
How do I overcome that? I trade this as I would a long-term stock position by either:
- Dollar-cost averaging in the LEAPs position by buying another call
- Close the position at a price level that is consistent with how I would be managing the stock position.
I ALWAYS use the stock’s price as the indication that it is time to close the option position, never the option price. This is a long-term investment and I plan to manage it that way…
Second, I plan on selling covered calls on the LEAP position when it is in the money. This means that I could have the LEAP called away from me if the calls I write were to go in the money. Again, I plan to manage this as I would a long-term stock position. This means that I may have to be willing to buy those covered calls back to cover the risk of having the stock called away. Or… perhaps the stock is starting to look toppy and I wouldn’t mind having the LEAP called away? In that case, I revert back to my point that I will be managing this as a long-term stock investment.
There you have it. A way to take a long-term investment in a high-flying stock like NVIDIA without breaking the bank while also getting some of the benefits of options that we all truly love.
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June 09 2023
