Strategies

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Weekly Strategy Discussion

The Weekly Strategy Discussion is designed to assist individuals in learning how options work and in understanding various options strategies. Options involve risk and are not suitable for all investors. The strategies discussed are for educational and illustrative purposes only, and should not be construed as an endorsement, recommendation or solicitation to buy or sell securities. Commissions, taxes and transaction costs are not included. Please contact a tax advisor for the tax implications involved in these strategies.

LEAPS as a Stock Alternative

(LEAPS options are Long-term Equity AnticiPation Securities, with expiration dates up to 39 months from the date of the initial listing.)

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 2001 with a strike price of 35, paying an option premium of $24 1/4 ($2425).

Alternative 1
Buy 100 XYZ (margin) @ $56

Alternative 2
Buy 1 XYZ Jan (01) 35 Call @ 24 1/4
Cash Down
$2,800

Cash Down
$2,425
Borrow
$2,800

Borrow
-0-
Carry Cost
$388 (2,800 x 9% x 80 wks)

Carry Cost
$325 (LEAPS time premium)




($59.25 - $56) x 100
(Dividends)
($198)

(Dividends)
(-0-)
Net Carry
$190

Net Carry
$325
Breakeven
$57.90/share

Breakeven
$59.25/share
RISK
$5,600 (+margin int. - dividends)

RISK
$2,425 (premium paid)

If held to LEAPS expiration, a comparison of these two strategies shows the following:

1. 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. (Delta is the measure of the rate of change in an option's theoretical value for a one-unit change in the price of the underlying security.) The total risk of owning the LEAPS call is $2425 (without commissions) versus total risk of stock ownership of $5,600.
2. 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.
3. Breakeven stock price for the LEAPS call is slightly higher than that of the margined stock purchase.
4. Remember: LEAPS have no dividends or votes, unlike stock. LEAPS expire, stock shares do not.

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