43 lines
2.4 KiB
Plaintext
43 lines
2.4 KiB
Plaintext
376 Part Ill: Put Option Strategies
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er. More and more people are examining the potential of selling the stock they own
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and buying long-term calls (LEAPS) as a substitute, or buying LEAPS instead of
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making an initial purchase in a particular common stock.
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Substitution for Stock Currently Held Long. Simplistically, this strate
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gy involves this line of thinking: If one owns stock and sells it, an investor could rein
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vest a small portion of the proceeds in a call option, thereby providing continued
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upside profit potential if the stock rises in price, and invest the rest in a bank to earn
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interest. The interest earned would act as a substitute for the dividend, if any, to
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which the investor is no longer entitled. Moreover, he has less downside risk: If the
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stock should fall dramatically, his loss is limited to the initial cost of the call.
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In actual practice, one should carefully calculate what he is getting and what he
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is giving up. For example, is the loss of the dividend too great to be compensated for
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by the investment of the excess proceeds? How much of the potential gain will be
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wasted in the form of time value premium paid for the call? The costs to the stock
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owner who decides to switch into call options as a substitute are commissions, the
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time value premium of the call, and the loss of dividends. The benefits are the inter
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est that can be earned from freeing up a substantial portion of his funds, plus the fact
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that there is less downside risk in owning the call than in owning the stock.
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Example: XYZ is selling at 50. There are one-year LEAPS with a striking price of 40
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that sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates
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are 5%. What are the economics that an owner of 100 XYZ common stock must cal
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culate in order to determine whether it is viable to sell his stock and buy the one-year
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LEAPS as a substitute?
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The call has time value premium of 2 points (40 + 12 - 50). Moreover, if the
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stock is sold and the LEAPS purchased, a credit of $3,800 less commissions would
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be generated. First, calculate the net credit generated:
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Credit balance generated:
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Sale of 1 00 XYZ stock
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Less stock commission
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Net sale proceeds:
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Cost of one LEAPS call
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Plus option commission
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Net cost of call:
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Total credit balance:
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$5,000
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25
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$4,975 credit
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$3,760 credit
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$1,200
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15
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$1,215 debit
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Now the costs and benefits of making the switch can be computed: |