Buying Index LEAPS Calls

The LEAPS Option Strategy Workshop is a collection of discussion pieces designed to assist individuals in learning how options work and in understanding various LEAPS options strategies. These discussions and materials are for educational purposes only and are not intended to provide investment advice.

Investment decisions should not be made based upon worksheet outcomes.

Access to, or delivery of a copy of, the Options Disclosure Document must accompany this worksheet.

Buying Index LEAPS Calls To Enhance Portfolio Returns

Market Assumption: Bullish
Situation: 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.

Original cost: 4.75 x 4 x 100=($1,900.00)
Value at expiration or sale/exercise: 19.35 x 4 x 100 = $7,740.00
Total profit: $5,840.00

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
Total earnings: = $11,131.00
Annual return on $50,000: = 10.59%

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.

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