Want to increase your return by as much as ten-fold while reducing your risk? Try trading LEAPS. Here is an example of why they work.
I usually focus on micro-caps, because returns in micro-cap land are usually a lot more attractive than returns in large-cap land.
But sometimes I venture into large caps if an opportunity looks especially attractive.
One other appealing aspect of large-cap stocks is that they have LEAPS.
Long-term Equity Anticipation Securities (LEAPS) are options contracts with expiration of more than one year.
Unfortunately, they are not available for any micro-caps, but most large-cap stocks have them.
If you are bullish on a stock, LEAPS can be a great way to express your view.
Essentially, LEAPS offer a cheap source of leverage.
Let me explain.
How LEAPS Work
I closely follow the stock spin-off world as I’ve learned that it’s a fertile area for generating alpha.
GlaxoSmithKline (GSK) recently confirmed that it would spin off its consumer business.
As a reminder, Glaxo created the business in 2018 when it merged its consumer business with the consumer business of Pfizer (PFE). The transaction combined GSK’s consumer brands like Theraflu and Sensodyne with Pfizer’s (Advil, Robitussin, etc.).
Per terms of the announcement, GSK owns 68% of the joint venture while Pfizer owns the remaining 32%.
Recently, GSK confirmed that the consumer division would be spun off into an independent public company by the middle of 2022. Based on my analysis, I think there is upside to GSK based on this spin-off.
Assuming the consumer division trades at 22x EBIT (P&G trades at 23x) and GSK trades at 12x (pharma peers trade at >20x), GSK is worth $52, implying ~23% upside.
While 23% upside is nothing to scoff at, it is usually not enough to get me excited about a stock.
But in the case of Glaxo, we can use LEAPS to make the trade significantly more attractive.
Trading LEAPS in GlaxoSmithKline
Today, we can buy GSK January 40 Calls (expiring 1/20/2023) for $4 (disclosure: I’m long).
If we are right, and within a year and a half GSK trades at $52, our calls will be worth $12 ($52 minus $40 strike price).
By using LEAPS, we can change a 23% upside scenario into a potential 200% upside scenario.
Essentially, these LEAPS provide us with a cheap source of leverage.
If we bought 100 shares of GSK at 42, it would cost us $4,200. If the stock increased to 52, we would make a profit of $1,000 (52-42 x 100).
But by using LEAPS, you can achieve the same upside potential but with significantly less money at risk ($400).
Why does this opportunity exist?
Options are priced in large part based on historical volatility. Because Glaxo has been a low volatility stock, its LEAPS are priced cheaply.
Of course, leverage works both ways. If GKS is worth 35 at expiration, our call will expire worthless.
But I do have confidence that the stock is at least moderately undervalued.
Further, it’s reassuring that famed activist investor Elliott Management agrees.
Elliott recently disclosed that it owns a multi-billion-dollar position in the stock and released a letter to the board of directors which calls for improved performance.
There’s a lot to like about GlaxoSmithKline in the next year-plus. And that makes it a prime candidate for LEAPS.
Have you traded LEAPS before? How have they performed? Tell us about your experiences in the comments below!