39 lines
2.9 KiB
Plaintext
39 lines
2.9 KiB
Plaintext
Chapter 25: LEAPS 381
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In summary, a prospective purchaser of common stock may often find that if
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there is an in-the-money option available, the purchase of that option is more attrac
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tive than buying the common stock itself. If he were planning to buy on margin, it is
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even more likely that the LEAPS purchase will be attractive. The main drawback is
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that he will not participate if cash dividends are increased or a special dividend is
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declared. Read on, however, because the next strategy may be better than the one
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above.
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PROTECTING EXISTING STOCK HOLDINGS WITH LEAPS PUTS
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What was accomplished in the substitution strategy previously discussed? The stock
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owner paid some cost ($102 in the actual example) in order to limit the risk of his
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stock ownership to a price of 39½. What if he had bought a LEAPS put instead?
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Forgetting the price of the put for a moment, concentrate on what the strategy would
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accomplish. He would be protected from a large loss on the downside since he owns
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the put, and he could participate in upside appreciation since he still owns the stock.
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Isn't this what the substitution strategy was trying to accomplish? Yes, it is. In this
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strategy, only one commission is paid- that being on a fairly cheap out-of-the-money
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LEAPS put - and there is no risk of losing out on dividend increases or special divi
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dends.
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The comparison between substituting a call or buying a put is a relatively sim
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ple one. First, do the calculations as they were performed in the initial example
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above. That example showed that the stockholder's cost would be $102 to substitute
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the LEAPS call for the stock, and such a substitution would protect him at a price of
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39½. In effect, he is paying $152 for a LEAPS put with a strike of 40- the $102 cost
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plus the difference between 40 and the 39½ protection price. Now, if an XYZ 1-year
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LEAPS put with strike 40 were available at 1 ½, he could accomplish everything he
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had initially wanted merely by buying the put.
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Moreover, he would save commissions and still be in a position to participate
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in increased cash dividends. These additional benefits should make the put worth
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even more to the stockholder, so that he might pay even slightly more than 1 ½ for
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the put. If the LEAPS put were available at this price, it would clearly be the bet
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ter choice and should be bought instead of substituting the LEAPS call for the com
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mon stock.
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Thus, any stockholder who is thinking of protecting his position can do it in one
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of two ways: Sell the stock and substitute a call, or continue to hold his stock and buy
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a put to protect it. LEAPS calls and puts are amenable to this strategy. Because of
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the LEAPS' long-term nature, one does not have to keep reestablishing his position
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and pay numerous commissions, as he would with short-term options. The stock
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holder should perform the simple calculations as shown above in order to decide |