Taking The LEAP Into Stock Options

Reserving the right to purchase stock later offers both risk and reward. Here's how to carefully get a handle on it all.

last year and is currently more than double what it was five years ago. What’s more, says Gina McFadden, a spokeswoman for the Council, is that by some estimates individual investors make up 60% of the market.

That said, there’s no reason to gasp or do a double-take if you’re the most timid investor around. Yes, options have a reputation for risk that is well earned. They can often be a highly speculative way to play the market, one where investors can make tremendous gains or fall to financial ruin. “Options aren’t for everyone,” says Hamilton Lewis, a Houston money manager who regularly trades options for clients. “I only advise considering them if you have a bit of steel in your nerves and a bit of money you’re willing to risk, because often, things can get speculative.”

If you don’t play it safe, options can be a great deal more hazardous to your financial health than stocks. For the faint of heart, that’s something akin to a monster roller coaster ride rather than a game of shuffleboard. But if you’re careful, prudent and follow some conservative steps, you can use options to help decrease investment risk.

For one, we’ll try to limit the amount of money in play as much as possible. Options on stocks can often increase in value at an astronomical rate. Then again, options on stocks that decrease can lose their entire value in one fell swoop. So, for prudent investing, it only makes sense to limit your exposure.

We’ll also hold to a long-term outlook. Options can often amount to short-term (say, two to three month) bets on just what the market or certain stocks will do. “For many individual investors, that’s the same as playing a lottery ticket,” says Peter A. Biebel, head of options trading at A. G. Edwards in St. Louis. Since things get exceedingly iffy over a short time horizon, we’ll sidestep that. Instead, our focus is on using options as a way to hedge long-term stock purchases, a method to decrease the amount of money you stand to lose. We’ll focus on one particular type of option called LEAP, or long-term equity anticipation note. Because LEAPs extend out two to three years, they often cushion your investment from sudden turns of fate. And in the following pages, we’ll spell out a number of scenarios where you might find LEAPs useful.

One thing bears mentioning, though. Options are often all-or-nothing investments where you come out big or lose your money. Since the prudent investor m all of us should keep an eye on the downside, we’d suggest that you not make your first investments in options. Instead, it’s better to have a portfolio anchored in a few core holdings, several stocks and a mutual fund or two.

First, to understand how option investing works, it’s best to learn some industry lingo. We’ll start with a definition of just what an option is. In simple terms, an option is a contract allowing you the right to

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