LEAPS Masterclass: Options Scenario #1 - The Basics / by DED

Option Scenario #1 - The Basics

A call is merely the right—but not the obligation—to buy a stock at a specified price for a limited period of time. So a June call to buy APPLE at $140 per share gives the owner of the call the right to buy APPLE at a price of $140 per share gives the owner of the call the right to buy APPLE at a price of $140 per share until the call expires in June (the third Friday of each month is considered the expiration date for listed options). If at the expiration date APPLE stock is trading at $148, the call would be worth $8. This is because the right to buy stock at $140, when the stock can be immediately resold for $148, is worth $8. If, on the other hand, APPLE stock is trading at only $135 on “the call’s expiration date, then the call expires worthless. This is because the right to buy stock at $140 (usually referred to as the strike or exercise price) isn’t worth anything if everyone can just go out into the marketplace and purchase the same stock for $135. Well, that just about covers the basics—except there’s one more step.  

Pretty much whenever the stock market is open, the options market is also open. There aren’t listed options available for every stock that trades, but options do trade on thousands of the largest companies. Therefore, if a stock has listed calls, you can usually buy and sell them during market hours up until their respective expiration date. In our example, the June $140 calls to buy APPLE stock were trading for months prior to their June expiration. We’ve already discussed what the call would be worth on its expiration date. The question is: What is the fair value of the call before the expiration date? To be more specific, how much should you pay for the calls if you buy them in April, approximately two months before they expire?

Let’s assume that APPLE is trading at $148 in April, two months prior to June expiration. We already know that, if it were the third Friday in June, these APPLE calls would be worth $8. In April, however, these calls are worth more than $8. They’re more likely to be trading closer to $11.375. Why? There are really two reasons. First, the owner of the calls doesn’t have to lay out $140 for another two months, yet he is entitled to all of the stock’s appreciation until June. Think about it. If APPLE stock were to gain another $10 per share by June expiration, then APPLE would be trading at $158. The owner of stock (since April) would have a gain of $10 on his $148 investment. On the other hand, if the APPLE June $140 calls could be purchased for only $8 in April, then the owner of an $8 call option would also make $10 in the same two-month period. (That’s because, on the expiration date, the owner of the call could purchase stock at $140 and sell it for $158; after subtracting the $8 initial cost, the profit would be $10.) This result wouldn’t be fair.

After all, the owner of the stock laid out an additional $ 140 for the same amount of profit. The owner of the call received the upside in APPLE’s stock without having to invest an additional $140. To compensate for this, the amount of interest that could have been earned on the $140 for the two months until expiration should be reflected in the price of the call. It is. Assuming a 6-percent interest rate, the interest earned on $140 would be approximately $1.40 per share. So, in addition to what’s known as the intrinsic value of the call—the amount by which the call is already in the money (in our example, the difference between the market price for APPLE of $148 and the exercise price of the call of $140, or $8)—an imputed interest rate for the amount of money the call buyer didn’t have to lay out for the two months is also included in the call price. That’s how we move from a call price of $8—the intrinsic value of the call—to approximately $9.40—the value of the call including the interest on the $140 the buyer of the call didn’t have to lay out.

But I said the call should trade at approximately $11.375. What accounts for the nearly $2 difference between the $9.40 we already figured and the actual price of $11.375? Clearly, there has to be another benefit to owning calls—and there is. The buyer of the call can only lose the amount of money invested in the call. While this doesn’t sound all that great, when you compare it to owning the common stock of APPLE, it is. This is because, at the June expiration date, if APPLE stock falls to $140 per share, the owner of the call loses his original investment of $11.375. If APPLE stock falls to $130 per share, the owner of the call loses the same $11.375—at $120 per share, or even $80 per share, the call owner only loses $11.375. Sounding better yet?”

It’s pretty obvious what happens to the poor owner of APPLE stock in this scenario. At a price of $140 at the June expiration date, the APPLE holder is down $8 from his April purchase price of $148. At a price of $130 in June, he’s out $18; if APPLE’s at $120 he’s out $28; and at a price of $80—the loss gets really ugly—he’s out $68 per share. See, there is an added benefit to owning the calls—it’s the benefit of not losing any more money after the stock falls below the strike (or exercise) price of $140 per share. What’s that worth? Well, in this case, it’s probably worth about $2. So, if you pay the $2 in “protection money” as part of the purchase price of the calls, then your cost of $9.40 moves closer to the $11.375 price we talked about before. The $2 cost for assuming the risk below $140 is actually the same as the cost of the put option.

The bottom line is that buying calls is like borrowing money to buy stock, but with protection. The price of the call includes your borrowing costs and and the cost of your “protection”—so you’re not getting anything for free, but you are leveraging your bet on the future performance of a particular stock. You are also limiting the amount you can lose on the bet to the price of the call.

That’s why buying LEAPS, which are merely long-term options, can be an attractive way to trade your investment ideas.

While LEAPS don’t have an unlimited life, they can usually be purchased up to two and a half years before they expire. This often gives ample opportunity for the stock market to recognize the results from an extraordinary corporate change (like a spinoff or restructuring) or a turnaround in fundamentals (like an earnings gain or the resolution of an isolated or one-time problem). Additionally, two and a half years is often enough time for many just plain cheap stocks either to be discovered or to regain popularity. Since current tax law favors holding investments for more than one year, buying LEAPS is also a way to receive long-term capital gains treatment while receiving the leverage benefits of an option investment.

In most cases, your decision to invest in LEAPS will simply be a by-product of your ongoing research efforts. Before you even begin thinking about LEAPS, a special situation or an undervalued stock will catch your attention as an attractive investment in its own right. Only after an investment passes this first hurdle will you bother to check whether a chosen investment situation has LEAPS available for trading. At the very least, being able to compare the risk/reward of a stock with the opportunities available through an investment in the related LEAPS will provide you with another good investment choice.

Thanks,
Matt


This is for education purposes only, past performance is never indicative of future results, this is not advice, nor am I or OP responsible for anything you do in your own account so don’t be dumb because it’s on you.  This is a social network for traders not Goldman Sachs.