Investing in Growth Stocks using LEAPS®

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.

LEAPS®, or Long-term Equity Anticipation Securities, are long-term stock or index options that expire more than 9 months in advance, and can last as long as 2 to 3 years. They are significantly cheaper to own than the underlying stocks and possess what I consider to be built-in stop-loss protection.

If you believe that a stock is a potential multi-bagger in 2 to 3 years time, then buying slightly out-of-the-money LEAPS® calls is a solid strategy that offers the important benefits of leverage and downside protection. To see how LEAPS® are able to offer the benefits I just highlighted, let's consider some of the characteristics of high growth stocks.

First of all, they are expensive. As these companies have been growing for the past few quarters, their price/earning ratios are usually very high as market expectations are high. This also means that a single quarter of missed earnings, no matter how minor, can potentially cause the market to overreact and the stock price to come crashing down - not too cool if you are holding on to the stocks. With LEAPS® however, your loss is limited to the premiums paid for the options.

On the flip side, should this stock turn out to be the multi-bagger as you had envisioned, you are looking at enormous returns on investment. This is because LEAPS® cost a fraction of the price of the stock and a tripling of the underlying stock price will result in an ROI exceeding 1000%, turning a 3-bagger into a 10-bagger!

The primary concern with owning LEAPS® is that like all options, they are wasting assets. However, I personally think that if your potential multi-bagger fails to achieve stardom in 2 to 3 years time, then chances are that it will never achieve the greatness and when that piece of information sinks in with the investors, the market will usually be pretty hard on the stock price. This is not uncommon. I’ve witness prices of hot stocks plummet from the fifties to single digits in a matter of weeks. Good thing you are holding on to the LEAPS® instead.

Probably the most unfortunate issue with LEAPS® is that they are usually available only for popular stocks and are seldom traded for small cap stocks - the stage where most of the potential ten baggers are hiding in.

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