In an earlier post, I discussed the possibility of leveraging the Magic Formula using LEAPS -- which are long term options to purchase a particular stock at a given price. There are three benefits that I see to using LEAPS to leverage the formula (as opposed to using a margin loan). The first involves the margin call. If you take out a margin loan, you could be forced to sell at the worst possible time if your overall holdings drop to the point where there is no longer enough equity in your account to cover your margin loan. With LEAPS, there is no such risk that you would be forced to sell during a sudden and rapid drop in equity prices.
I believe that there may also be a tax benefit to using LEAPS. With a LEAP, the amount that you pay for "interest" is built into the option itself -- eliminating the possibility that you will be paying capital gains on amounts that you actually had to pay in financing charges. You also may be able to deduct your margin interest, but the rules are complicated, and you are not allowed to add the interest charges to the basis you have in your stock. (Admittedly, I am not that fresh on the IRS regulations re: deducting margin interest from your capital gains).
The third benefit of LEAPS is that you can decide for yourself how much leverage you want to use. You can be conservative and buy LEAPS that are solidly "in the money," or you can put down very little and buy LEAPS that are highly leveraged and must rise several percentage points. I tend to favor a more conservative approach, but the flexibility is there if you want to go with more leverage than your margin account will allow.
The main downside to using LEAPS -- which a reader pointed out in an earlier post -- is that you can only buy LEAPS on large cap stocks. I've run the MFI using stocks with market caps above 1000, and most of these have 1 and 2 year LEAPS. The MFI approach works for large cap stocks, but, as Joel points out in his book, returns have not been as high as those for small cap stocks.
Your thoughts?
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2 comments:
I've also thought about leveraging the MFI using LEAPs. I guess that's what happens when you read the two JG books back-to-back. I haven't tried it yet, but I think that I will starting next year.
Just to add to your comment about how aggressive or conservative to be with LEAPs, you can also determine this to some extent by buying closer or further expiry dates, as well.
PS - your blog entry inspired me to revisit LEAPs in my blog. would be interested in your thoughts... http://investoblog-j.blogspot.com/2006/12/my-experiment-in-leaps.html
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