Investing in a diversified portfolio of stocks and bonds is taught as a wise decision for investors who want their money to work for them and increase their wealth. However, the recent bank failures of Silicon Valley Bank and Signature Bank on March 10, 2023, have highlighted the risks investors face when investing in potentially falling assets.
The fear and anxiety that come with the possibility of losing their hard-earned money can cause emotional turmoil for investors. These events are eerily reminiscent of what happened during the Great Recession of 2008-2009 when investors saw their net worth plummet as the values of their assets declined due to problems with the global economy and the banking system.
In times of crisis, the US government has historically stepped in to provide stability and save investors. However, as demonstrated by recent events, this level of involvement is not guaranteed in the future. The next crisis could cause a catastrophic collapse in assets, destroying investors’ net worth.
This article highlights the risks associated with direct investments in assets like stocks and real-estate and explores how using derivatives like LEAPS can help investors manage risk without giving up their maximum upside potential. Moreover, we will discuss how using LEAPS can allow investors to take advantage of market movements and how it can help investors “buy low” and protect their portfolios against market downturns.
The Risks of Direct Investments in Assets
You have probably been told time and time again that successful investors buy assets to build wealth, right? The problem with this thought process is investors who invest directly in assets like stocks, and real estate are vulnerable to market volatility and economic downturns. When the values of these assets decline, investors can lose a significant portion of their net worth, which can cause emotional turmoil and financial distress.
In times of crisis, the risks associated with direct investments in assets are magnified. The recent bank failures of Silicon Valley Bank and Signature Bank have highlighted the risks investors face when investing in potentially falling assets. These events are eerily reminiscent of what happened during the Great Recession of 2008-2009 when investors saw their net worth plummet as the values of their assets declined due to problems with the global economy and the banking system.
You may just believe that dealing with the possibility you could lose a large chunk of your net worth if things go wrong is just part of the price you need to pay if you want to play the game. If so, I have great news: It is not. Therefore, I want to introduce you to financial security that doesn’t get much attention but could change everything you believe about investing and building wealth. That security is LEAPS…
Long-term Equity Appreciation Securities
LEAPS, or Long-term Equity Anticipation Securities, are financial instruments that give investors the right to buy or sell an underlying asset, such as a stock or an index, at a specific price and date in the future. LEAPS are sold by both the brokerage firms and financial institutions as well as the market makers, who facilitate the buying and selling of options contracts. The market makers play an important
role in the options market by providing liquidity, buying and selling options contracts, and ensuring that there is always a buyer or seller for each contract. In addition to the major brokerage firms like Charles Schwab, TD Ameritrade, and E*TRADE, market makers like Citadel Securities, Virtu Financial, and Jump Trading are also active participants in the LEAPS market. With the wide range of options available from different market makers and brokerage firms, investors have plenty of opportunities to manage risk and take advantage of market movements through the use of LEAPS
| Pros of using LEAPS | Cons of using LEAPS |
|---|---|
| Provides the ability to manage risk without giving up maximum upside potential | Can be complex and require a certain level of expertise to use effectively |
| Provides flexibility to take advantage of market movements and protect portfolio against market downturns | Higher transaction costs than buying index funds |
| Can provide comfort, stability, and flexibility in investment strategy | Can be less tax-efficient than buying index funds |
| Allows investors to “buy low” by giving them the cash they need to take advantage of market movements | |
| Requires only a fraction of an investor’s wealth, freeing up equity for other investments that can earn a return to offset the cost of acquiring the LEAPS |
Using LEAPS to Manage Risk
When I wrote “Comfort Investing” in 2013, I explained how using LEAPS to speculate on the price direction of an underlying asset can provide investors with comfort, stability, and flexibility in their investment strategy. LEAPS contracts have longer expiration dates than traditional options contracts, allowing investors to hold positions for an extended period. Moreover, using LEAPS can provide investors with the ability to manage risk without giving up their maximum upside potential.
When investors use LEAPS, they only have to risk a percentage of their wealth to get the same returns as when directly investing in the underlying asset. This means that a portion of the investor’s wealth is freed up and can be positioned to earn a rate of return that can offset the premium paid for the LEAPS.
Moreover, using LEAPS can allow investors to “buy low” by giving them the cash they need to take advantage of market movements. When the prices of underlying assets are low, investors can use their available cash to purchase additional assets, providing more diversification and reducing their overall risk.
Using LEAPS can also give investors the flexibility to take advantage of market movements without making large trades. This can allow investors to generate income or protect their portfolios without having to commit a large amount of capital. This can provide more stability in their investment strategy and help them achieve their financial goals over the long term.
One way to use LEAPS to manage risk is to buy a call option on a LEAP with a strike price that is lower than the current price of the underlying asset. This allows investors to speculate on the asset’s price direction while limiting their potential losses if the price goes down. If the price of the asset goes up, investors can exercise their option to buy the asset at the lower strike price and then sell it at the higher market price, realizing a profit. If the price of the asset goes down, investors can let their option expire, limiting their losses to the premium paid for the LEAP.
Another way to use LEAPS to manage risk is to buy a put option on a LEAP with a strike price higher than the underlying asset’s current price. This allows investors to speculate on the asset’s price direction while limiting their potential losses if the price goes down. If the price of the asset goes down, investors can exercise their option to sell the asset at the higher strike price and then buy it back at the lower market price, realizing a profit. If the price of the asset goes up, investors can let their option expire, limiting their losses to the premium paid for the LEAP.
It is important to note that using LEAPS to manage risk requires investors to thoroughly research and understand the risks and benefits of using LEAPS or any other financial instrument before using them in their investment strategies. Moreover, investors should always consult a financial advisor before making investment decisions.
The equity that is freed up when using LEAPS creates new opportunities from a financial planning and investing standpoint that are not available to those who invest directly in stocks. This can include investing in other assets that can help diversify the investor’s portfolio and reduce their overall risk.
Investing in a diversified portfolio of assets can help protect the investor’s portfolio against market volatility and economic downturns. By investing in different assets, investors can reduce their overall risk by spreading it across different types of assets that are not correlated with each other. For example, investing in bonds can provide a steady stream of income and act as a hedge against inflation, while investing in commodities can provide a hedge against currency fluctuations and provide diversification.
Moreover, investing in real estate can provide long-term growth potential and income, as well as act as a hedge against inflation. Investing in private equity can provide access to companies that are not publicly traded and can provide higher returns than traditional investments. By diversifying their portfolio across different types of assets, investors can reduce their overall risk and achieve their financial goals over the long term.
Using LEAPS to manage risk can provide investors with the ability to take advantage of market movements and protect their portfolio against market downturns. When used properly, LEAPS can provide investors with comfort, stability, and flexibility in their investment strategy. Moreover, using LEAPS can provide investors with the ability to “buy low” by giving them the cash they need to take advantage of market movements.
However, using LEAPS can also be complex and require a certain level of expertise to use effectively. Moreover, LEAPS can have higher transaction costs than buying index funds, and they can be less tax-efficient than buying index funds.
Therefore, it is important for investors to thoroughly research and understand the risks and benefits of using LEAPS or any other financial instrument before using them in their investment strategies. Moreover, investors should always consult with a financial advisor before making any investment decisions.
Conclusion
Investing in a diversified portfolio of assets seems to be the correct and wise decision for investors who want their money to work for them and increase their wealth. However, investing directly in assets like stocks and real estate can be risky, especially during times of crisis.
Using derivatives like LEAPS can help investors manage risk without giving up their maximum upside potential. Moreover, using LEAPS can allow investors to take advantage of market movements and protect their portfolios against market downturns. When appropriately used, LEAPS can provide investors with comfort, stability, and flexibility in their investment strategy.
However, using LEAPS can also be complex and require a certain level of expertise to use effectively. Therefore, it is important for investors to thoroughly research and understand the risks and benefits of using LEAPS or any other financial instrument before using them in their investment strategies. Moreover, investors should always consult with a financial advisor before making any investment decisions.
