Buying Equity LEAPS Calls As A Stock Alternative
Buying deep in-the-money LEAPS can represent an alternative to owning stock. Purchasing a LEAPS call can lower cost, reduce risk, and provide a return similar to owning shares outright. There are important differences, discussed below.
Example: An investor wishes to buy shares of stock XYZ, which is trading at 56. In order to
conserve capital the investor thinks about buying the shares on margin, putting up half the cost
of 100 shares ($2800) and borrowing the balance ($2800) at a margin rate of 9%. The investor
could instead think about purchasing a LEAPS call on XYZ expiring in Jan 2000 with a strike price
of 35 paying an option premium of $24.25 ($2425).
Alternative 1
Buy 100 XYZ (margin) @ $56
|
Alternative 2
Buy 1 XYZ Jan (00)35 call 24.25 |
| Cash down |
$2,800 |
Cash down |
$2,425 |
| Borrow |
2800 |
Borrow |
-0- |
| Carry Cost |
388 ($2800 X 9% X 80 wk.) |
Carry Cost |
325 (LEAPS time premium) |
| Less dividends |
-198 |
Less dividends |
-0- |
| Net carry cost |
$190 |
Net carry cost |
$325 |
| Breakeven |
57.9 / share |
Breakeven |
59.25 / share |
| RISK |
$5,600 (+ margin int. -dividends) |
RISK |
$2,425 |
If held to LEAPS expiration, a comparison of these two strategies shows the following:
- The investor now owns a deep-in-the-money LEAPS call on XYZ which should perform almost the same as owning the shares, due to the option's relatively high delta. The total risk of owning the LEAPS call is $2425 (without commissions) versus total risk of stock ownership of $5,600.
- The "carry cost" of buying a LEAPS is $135 more than the "carry cost" of purchasing the stock on margin. But the "cash down" payment for the LEAPS is lower.
- Breakeven stock price for the LEAPS call is slightly higher than that of the margined stock purchase.
- Remember: LEAPS have no dividends or votes, unlike stock. LEAPS expire, stock shares do not.
Commissions, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of option transactions and should be considered. The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security.
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