This New Tool Could Change Long-Term Investing
Sep 11th 2012 9:57AM
Updated Sep 11th 2012 9:58AM
Long-term investors haven't gotten much love from Wall Street lately. Even though a huge number of new investing products have come to market in recent years, ranging from leveraged exchange-traded funds and structured products to niche products like volatility-based ETFs, most of them are most appropriate for short-term traders, rather than those with a longer time horizon.
But long-term investors may get a useful new weapon in their investing arsenals soon. CBOE Holdings' (NAS: CBOE) Chicago Board Options Exchange has asked the Securities and Exchange Commission for permission to issue a brand-new type of option. If approved, it could act as a replacement for regular stock and potentially change the way you invest.
Many long-term investors ignore the options market because the lion's share of options trading involves short-dated options. With new options expiring every month, traders often try to take advantage of options either to capture small gains on a regular basis or to take a longshot at a big payoff if a stock moves dramatically.
But in an oft-neglected corner of the options market, you'll find longer-term options that don't expire for a year or more. These options, also known as LEAPS, let you get beyond immediate noise in stock price movements to try to capture a broader market trend. But even the longest-dated LEAPS don't let you get much more than a couple years' worth of exposure.
That's where the CBOE's new options come in. Dubbed "super options" by a Barron's article that discussed the new products over the weekend, the new options would offer expirations as far as 15 years into the future.
Most commentary on the proposal centers on the fact that super options would allow investors to lever their portfolios to a greater extent than buying stock outright. For instance, because call options always cost less than the underlying shares of stock, you can always buy more options on stock with a given amount of capital.
But the utility of ultra-long-term options for traditional long-term investors doesn't turn on greater leverage. Rather, they allow growth investors who don't rely on dividend income to use an investment that turns more on capital gains and less on dividends.
All this may sound theoretical, but investments very similar to ultra-long-dated options already exist. In connection with the TARP bailouts in late 2008 and early 2009, the U.S. Treasury obtained warrants from the financial institutions to which it provided capital. These warrants typically had 10-year expirations and gave the Treasury the right to buy additional shares at a specific price, closely resembling a call option. They don't trade in anything close to the volume as their underlying stocks, but they do trade. For instance, Bank of America (NYS: BAC) , Citigroup (NYS: C) , and Hartford Financial (NYS: HIG) are just a few of the many financial institutions with outstanding long-dated warrants.
Of course, we won't really know if warrants are a good investment until their expiration dates arrive. But the attributes they share with proposed ultra-long-dated options should reveal some useful information:
Warrants adjust for dividends only if payments exceed a certain amount. Similarly, the rules for most options leave strike prices unchanged unless a dividend is greater than a threshold percentage -- a situation that usually only comes up in connection with a special dividend.
Warrants trade cheaply enough to have a lot of upside potential. For instance, Citigroup warrants with a strike price of $106 expiring in early 2019 cost less than $0.50 per share now. With shares trading at just $32 per share, Citigroup would have to see colossal growth before warrant-holders would make a profit. But if stocks rise at a healthy clip over the next six years or so, then the potential gains are enormous.
Warrant prices rise and fall with volatility as well as share price movements. That makes them a less aggressive way to bet on increased turbulence than iPath S&P 500 VIX Short-term Futures (NYS: VXX) and other direct plays on volatility.
Ultra-long-dated options will be very interesting when they come out, but from a practical standpoint, they're likely to be difficult to trade at first. Until professionals figure out appropriate ways to assign prices to these options, the potential for mispricing is huge. That could present opportunities for astute investors, but it could also trip you up if you don't do your homework.
Looking far into the future is a challenge for every investor. But our top analysts have looked at prevailing trends to make some guesses about the future of major companies. For instance, our premium report on Bank of America gives you insight about the bank's future prospects and will continue to do so with a year's worth of free updates. Check it out today.
The article This New Tool Could Change Long-Term Investing originally appeared on Fool.com.Fool contributor Dan Caplinger keeps his options open. You can follow him on Twitter @DanCaplinger. He owns warrants on Hartford Financial. The Motley Fool owns shares of Bank of America and Citigroup.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't optional.
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