LEAPS® Strategies
Buy LEAPS® Calls
An investor anticipates that the price of ZYX stock will rise during the next two years. This investor would like to profit from the increase without having to purchase shares of ZYX.
ZYX is currently trading at $50.50 and a ZYX LEAPS® call option, with a two-year expiration and a strike price of $50, is trading for a premium of $8.50 or $850 per contract. The investor buys five contracts for a total cost of $4,250, which represents the total risk of the call position. The calls give the investor the right to buy 500 shares of ZYX between now and expiration at $50 per share regardless of how high the price of the stock rises. To be profitable, though, at expiration, the stock must be trading for more than $58.50, the total of the option premium ($8.50) and the strike price of $50. The buyer's maximum loss from this strategy is equal to the total cost of the options or $4,250. The break-even point for this strategy is $58.50.
The following are possible outcomes of this strategy at expiration.
Stock above the break-even point
If ZYX advances to $65 at expiration, the LEAPS® will have a value of approximately $15 (the stock price of $65 less the strike price of $50). The investor may choose to exercise the calls and take delivery of the stock at a price of $50, or may sell the LEAPS® calls for a profit.
Stock below the strike price
If ZYX, at expiration, is trading for less than the strike price, or below $50 in this example, the unexercised calls will expire worthless. In this case, the investor will incur the maximum loss of $4,250.
Stock between the strike price and the break-even point
If ZYX, at expiration, has risen to $56, the calls will be valued at approximately $6 (the stock price of $56 less the strike price of 50) and will represent a partial loss given the break-even point of $58.50. The calls purchased by the investor for $8.50 will, upon exercise, then be worth approximately $6, creating a loss of $2.50 or $250 per contract. If the investor does not exercise or sell these options, the investor will lose all of the initial investment, or $850 per contract.
Prior to expiration, the LEAPS® may trade at a price that is somewhat higher than the difference between the $50 strike price and the actual stock price. This difference is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration. Time value is one of the components of an option premium and generally decreases as expiration approaches.
Buy LEAPS® Puts
The purchase of LEAPS® puts to hedge a stock position may provide investors protection against declines in stock prices. This strategy is often compared to purchasing insurance on one's home or car, and may give investors the confidence to remain in the market. The amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost, should be considered.
For example, ZYX is trading at $45 and a ZYX LEAPS® put with a three-year expiration and a strike price of $42.50 is selling for $3.50 or $350 per contract. These puts provide protection against any price decline below the break-even point, which for this strategy is $39 (strike price less the premium). The investor's risk or maximum loss is limited to the total amount paid for the put options or $350 per contract. The following are possible outcomes of this strategy at expiration.
Stock above the break-even point
If ZYX is trading at $48 at expiration, the unexercised put would generally expire worthless, representing a loss of the option premium or $350 per contract.
Stock below the strike price
The put would be profitable if the stock closed below 39 at expiration. If ZYX is trading at $37.50 at expiration, the $42.50 put, upon exercise, would have a value of $5 or $500, representing a profit of $1.50 or $150 per contract. This profit will partially offset the decline in the value of the stock.
Stock between the strike price and the break-even point
If ZYX is trading at $41.50 at expiration, the $42.50 put would be valued at approximately $1. This means that, upon exercise, a portion of the option premium would be retained and the loss would then be $2.50 points or $250 per contract. If the contract is not exercised or sold, the investor will lose all of the initial investment, or $350 per contract.
Sell LEAPS® Covered Calls
The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.
The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.
Investors should be aware of the risks involved in a covered call strategy.
The writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price. The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.
The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS® call. ZYX is currently trading at $39.50, and a ZYX LEAPS® call option with a two-year expiration and a strike price of $45 is trading at $3.25.
An investor owns 500 shares of ZYX at $39.50 per share and sells five of ZYX LEAPS® calls with a strike price of $45 at $3.25 each or a total of $1,625. The investor's objective is to obtain profits without selling the stock. The break-even point for this covered call strategy is $36.25 (the stock price of $39.50 less the premium received of $3.25). This represents downside protection of $3.25 points. A loss will be incurred if ZYX declines to below $36.25. Possible outcomes of this strategy at expiration are as follows.
Stock above the strike price
If ZYX advances to $50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of $45 less the price of the stock when the option was sold plus the option premium received of $3.25 X 100).
Stock below the break-even point
If ZYX is trading at $34 at expiration, the unexercised LEAPS® calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.
Stock between the strike price and the break-even point
If ZYX advances to $40 at expiration, the LEAPS® calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of $3.25 per share.
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