46 lines
2.4 KiB
Plaintext
46 lines
2.4 KiB
Plaintext
Chapter 25: LEAPS
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Costs of switching:
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Time value premium
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Loss of dividend
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Stock commissions
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Option commissions
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Total cost:
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Fixed benefit from switching:
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Interest earned on
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credit balance of $3,760
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at 5% interest for one year= 0.05 x $3,760:
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Net cost of switching:
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317
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-$200
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-$ 50
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-$ 25
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- .l__Ll_
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-$290
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+ $188
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- $102
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The stock owner must now decide if it is worth just over $1 per share in order
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to have his downside risk limited to a price of 39½ over the next year. The price of
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39½ as his downside risk is merely the amount of the net credit he received from
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doing the switch ($3,760) plus the interest earned ($188), expressed in per-share
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terms. That is, if XYZ falls dramatically over the next year and the LEAPS expires
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worthless, this investor will still have $3,948 in a bank account. That is equivalent to
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limiting his risk to about 39½ on the original 100 shares.
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If the investor decides to make the substitution, he should invest the proceeds
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from the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the
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current rate - the one used in his calculations - for the year. Second, he is not tempt
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ed to use the money for something else, an action that might negate the potential
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benefits of the substitution.
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The above calculations all assume that the LEAPS call or the stock would have
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been held for the full year. If that is known not to be the case, the appropriate costs
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or benefits must be recalculated.
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Caveats. This ($102) seems like a reasonably small price to pay to make the switch
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from common stock to call ownership. However, if the investor were planning to sell
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the stock before it fell to 39½ in any case, he might not feel the need to pay for this
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protection. (Be aware, however, that he could accomplish essentially the same thing,
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since he can sell his LEAPS call whenever he wants to.) Moreover, when the year is
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up, he will have to pay another stock commission to repurchase his XYZ common if
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he still wants to own it ( or he will have to pay two option commissions to roll his long
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call out to a later expiration date). One other detriment that might exist, although a
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relatively unlikely one, is that the underlying common might declare an increased
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dividend or, even worse, a special cash dividend. The LEAPS call owner would not
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be entitled to that dividend increase in whatever form, while, obviously, the common |