OUTSIDE THE BOX: Limiting Capital Outlay for Long-term Holdings with ITM LEAPS

If a retracement in a particular stock or in the stock market concerns you, try the deep-in-the-money call strategy, which closely simulates the movement of the stock with much less dollar risk than actually owning the stock.

For example, let us assume you like the outlook of XYZ shares, but are somewhat concerned about the possibility of war risk in its global operations, or you are worried that a stock market decline of 10 to 20 percent could occur. Assuming XYZ is at $50 per share, instead of buying the stock for $5,000 per 100 shares, you might buy a deep in-the-money LEAPS 30-strike call expiring in two years for around $2,300 to control those same 100 shares.

Taking a closer look at the LEAPS option purchase, we see that with the stock at 50, the 30-strike call is intrinsically worth 20 (50 – 30), or $2,000. So by paying a total premium of $2,300, you are paying only $300 in time premium for the right to hold this position for two years. The other cost you will implicitly incur relatively to owning the stock is that, as an options investor, you won’t be able to collect dividends. So as a LEAPS owner, you would be giving up this aspect of XYZ’s total return.

If XYZ shares should rise to 60 by LEAPS expiration, the stock owner makes a profit of $1,000, for a 20 percent gain. In comparison, the LEAPS 30-strike call will be intrinsically worth 30, meaning that your profit would be $1000, or 50 percent. So on a major upside move, you, as a LEAPS owner closely track the absolute dollar performance the stock owner receives, excluding dividends. And you have a fraction of percent of the dollars at risk in the LEAPS call relative to owning the stock,

The factor that creates the difference in the deep in-the-money options profile relative to the stock owner’s profile is the time premium paid. But in exchange for paying this time premium and foregoing dividends, you are able with LEAPS to significantly reduce your dollar exposure. If you have a shorter view that you expect to play out in one year or less, the time premium can be reduced. Or you can still buy the longest-term LEAPS options available but go even deeper in-the-money if you are willing to place more dollars at risk.

Keep in mind that for illustrative purposes we gave the results if the options investor held the LEAPS position until expiration, while in reality we would have either closed or rolled out the position before time decay played a major factor.

LEAPS offer stock investors an excellent vehicle to profit by allowing a big-picture trend on a stock to play out, with much less capital required than buying the stock. In this respect, LEAPS are less risky than their short-term option counterparts.

Happy Trading.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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