Buying Index LEAPS Calls To Enhance Portfolio Returns
An investor is of the opinion that the stock market will rise over the next three years.
Possible Market Action:
||Buy index LEAPS calls.
Assume an investor buys $50,000 of two-year Treasury notes with
an annual yield of 5.50%. Over the two years this investment
would earn $5,500. This investor would lock in this 5.50% return
but would not have the opportunity to increase that return if
the stock market rises. If this investor were bullish on the market
over the next two years he might be willing to risk slightly over
35% of the return on the notes in exchange for an opportunity
to increase his overall return. This could be accomplished by
investing the $1,900 that would otherwise be invested at 5.50%
in index LEAPS calls. The balance of the money ($48,100) would still be
invested in Treasury notes.
Assume that YZX LEAPS 1/10th reduced value index is currently valued at 60, (implying a YZX index
level of 600) and that the $1,900 would be used to purchase YZX at-the-money calls. If the two-year
December 60 calls cost approximately $4.75 per contract, the investor
could buy four for $1,900 (4.75 x $100 x 4) plus commissions.
If the index were to rise 15% per year for the next
two years, that would translate into the YZX having a value of
79.35 at expiration. Therefore, the calls with a 60 strike price
would be worth about 19.35 points at expiration.
4.75 x 4 x 100=($1,900.00)
Value at expiration or sale/exercise:
19.35 x 4 x 100 = $7,740.00
The combined return from the Treasury note and option positions
would be as follows:
Interest income:($48,100 x 5.50% x 2 yrs.)
= $ 5,291.00
Earnings from YZX position:
= $ 5,840.00
Annual return on $50,000:
The YZX LEAPS position, with the market rising 15% per year, increased the return over two years
from $5,651 (if all the funds had been invested in Treasury notes)
to $11,131.00 or an extra 5.04% per year.
The return from the YZX LEAPS calls obviously depends on stock market
movement. If the market rose at more than 15%, in this example,
the improvement in total return would be even greater. In this
example, the combined return from the Treasury note and YZX LEAPS investments will be greater
than a straight money market investment if the
selected index increases an average of 6.0% or more per year over the next two years.
No matter how poorly the stock market performs, the worst that
the investments could perform would be a loss of the $1,900 used
to purchase YZX LEAPS calls while still earning 5.50% on the $48,100
invested in Treasury notes. This results in a minimum return on
the original $50,000 of about 3.8% annually.
Purchasing the YZX LEAPS calls in this example reduces the assured rate
of return from 5.5% to about 3.8% in exchange for the opportunity to
earn more than 5.5%, if the stock market rises by more than an
average of 6.0% per year over the two years.
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.