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.


Buying in-the-money LEAPS® vs. Purchasing stock on margin

Purchasing in-the-money LEAPS sometimes presents a good alternative to buying a stock on margin, by offering lower risk and costs of entry. For example, an investor considering the purchase of XYZ on margin (currently trading at $94.50/share) could instead purchase a deep in-the-money XYZ July 2003 55 LEAPS call for $45. A comparison of these two strategies, omitting commissions, is outlined below:

Alternative 1: Buy 100 XYZ (on margin) at 94.50



Cash Down
$4,725.00
Borrow
$4,725.00
Carry Cost
$504.00 ($4,275 * 8% * 16 months)
Less Dividends
-0.00
Net Carry Cost
$504.00
Break-Even
$99.54/share
Risk
$9,954.00 (cost + margin int.)



Alternative 2: Buy 1 XYZ Jul '03 55 Call at 45


Cash Down
$4,500.00
Borrow
$0
Carry Cost
$550.00 (LEAPS time premium)
Less Dividends
-0.00
Net Carry Cost
$550.00
Break-even
$100.00/share
Risk
$4,500.00


If held to expiration, a comparison of the two strategies would show the following:

The deep in-the-money call should perform almost the same as the long stock position, due to the option's relatively high delta. The total risk of owning the LEAPS is less than half that of owning the shares ($4,500.00 vs. $9,954.00). Plus, because an option is paid for in full at purchase, there is no risk of a margin call with the LEAPS purchase.
The "carry cost" of purchasing the LEAPS is higher by $46.00 than the "carry cost" of purchasing the stock on margin (to do this we compare interest cost less dividends on the stock versus time-premium-decay "cost" on the options), but the "cash down" payment for the stock is higher than for the LEAPS by $225.00.
The break-even stock price for the LEAPS is close to that of the margined stock purchase.

Remember: LEAPS pay no dividends and carry no voting rights. Also, LEAPS expire, while stock does not.

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