Weekend Edition - Who Says Long-Term Investors Can't Use Derivatives?

Weekend Edition – Who Says Long-Term Investors Can’t Use Derivatives?

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In last week’s newsletter I touched on the concept known as the Dividend Diet. The Dividend Diet consists of huge helpings of consistently eating fundamentally sound, consistent dividend growers who have favourable outlooks to their business model over the long term. You’ll find our best ideas for individual stock holdings manifest themselves via our Best Dividend Stocks list, which is updated regularly and a monthly stock is featured in the monthly edition of the Dividend Advisor. That said, like a sustainable “way of eating” I touched on the concept that, at the margin, can be helpful for investors to speculate from time to time, using small amounts of risk capital. In an odd sense, using a small dose of speculation can strengthen the intestinal fortitude required to sustain and embrace the grind over the course of 20, 30, 40 or even 50 years of employing the long term approach of consistent dividend investing that is the pillar of our strategy at Dividend.com.

Today, I’d like to touch on a financial instrument, that despite Warren Buffett deeming it within the category of “weapons of financial mass destruction” because it is a derivative, if used carefully, sparingly and in an educated way can be–for some sophisticated investors–an interesting tool to fill as the desert portion of the Dividend Diet.

L.E.A.P.S.

First the basics, what are L.E.A.P.S.? Well, although I’d love to re-hash the definition, I’d find it tough to do better than Investopedia. LEAPS (short for Long Term Equity Anticipation Securities) are:

“Publicly traded options contracts with expiration dates that are longer than one year. Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts. The premiums for LEAPS are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.”

Thanks Investopedia.

LEAPS are a long term option, with long term defined as greater than 1 year. As you unpack LEAPS, you need to understand what options are. Well, options are:

“A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Call options give the option to buy at certain price, so the buyer would want the stock to go up.

Put options give the option to sell at a certain price, so the buyer would want the stock to go down.”

The bottom line is LEAPS can provide a sophisticated investor a leveraged instrument to bet on the up or downside potential they see in an an individual stock. Moreover, it can allow them to bet on the volatility within a stock as part of the LEAP pricing model–like options–would consist of volatility, underlying value of the security, time and discount rate or interest rate.

Given their elongated expiration dates, when compared to short term options contracts (most heavily traded stocks are option-able month by month), LEAPS are more aligned with a longer term investor. That said, they’re not truly “long term” as we’d think about the definition as dividend investors who live, eat and breathe our Dividend Diet and measure length in half decades, but, they can provide a nice option (pun intended) to add some dessert to a portfolio. The bet can be simple: look for a solid company that has LEAPS which you believe will rise substantially in price before the LEAPS expire. Know that you are out-and-out speculating as the fundamentals of the business may, in fact likely won’t, coincide with the LEAPS’ expiration though. If you’re right, you’ll enjoy a nice bump, if you’re wrong, you should be more than able to stomach a complete loss on a very small investment (relative to your portfolio).

Use small amounts of risk capital and know that when others are talking about their penny stocks, day trades or forex bets, you can chime in with your LEAPS position. You don’t need to tell them it’s a minuscule part of your strategy or portfolio, but psychologically, this can be a soothing counterbalance to the disciplined regimen we’re on in the core of the Dividend Diet.

Please enjoy the rest of the Independence Day long weekend, and we will be in touch tomorrow when the markets are back open in full swing.