Understanding Stock
Understanding Stock
Options
Options
LEAPSŪ for the
Experienced Trader
Marty Kearney
Disclosures
Options involve risks and are not suitable for everyone. Prior to buying or selling options,
an investor must receive a copy of Characteristics and Risks of standardized Options.
Copies may be obtained by contacting your broker or the Options Industry Council at 440
S. LaSalle St., Chicago, IL 60605
In order to simplify the computations, commissions, fees, margin interest and taxes have
not been included in the examples used in these materials. These costs will impact the
outcome of all stock and options transactions and must be considered prior to entering
into any transactions. Investors should consult their tax advisor about any potential tax
consequences.
Any strategies discussed, including examples using actual securities and price data, are
strictly for illustrative and educational purposes only and are not to be construed as an
endorsement, recommendation, or solicitation to buy or sell securities. Past performance
is not a guarantee of future results.
2
Presentation Outline
" Brief review of basics
" Why LEAPSŪ? Why bother?
" Strategies
Planning a stock purchase (or gift)
What stock traders should know
Covered writing with LEAPSŪ
LEAPSŪ protective puts and collars
A year-end (LEAPSŪ) tax strategy
3
LEAPSŪ - The Basics
" Long-term Equity AnticiPation Securities
" Expiration dates up to 2 1/2 years away
(i.e., January 2004, January 2005)
" Different symbols / strikes
" Meaningful strikes, premiums
" All types of strategies
4
LEAPSŪ - Rights & Obligations
CALLS PUTS
BUYERS RIGHT RIGHT
}
(holders) to buy to sell
SELLERS OBLIGATION OBLIGATION
}
(writers) to sell to buy
5
LEAPSŪ Terms
" Strike price
" Premium
" Expiration
" Exercise/Assignment (European / American)
6
LEAPSŪ - Ticker Symbols
Different root ticker symbols
Wal Mart Stock symbol: WMT
Regular Option symbol: WMT
LEAPS Symbols: LWT ZWT
Microsoft Stock symbol: MSFT
Regular Option symbol: MSQ
LEAPS Symbols: LMF ZMF
7
Options/LEAPSŪ Pricing
" Stock price
" Strike price
" Time to expiration
" Interest rate / dividends
" Volatility
Using options requires
more decisions!
8
Why LEAPSŪ? Why Bother?
LEAPS Time Decay
30
25
20
Short-term option
15
LEAPSŪ
10
5
0
36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0
Time in Months
9
*$100 stock, 100-strike call, 30% vol, 5% interest rate, no divs.
Price
LEAPSŪ Time Erosion
3-mo option 2-yr LEAP
Now: 3.40 11.00
1 month later: 2.75 10.70
2 months later: 1.90 10.40
3 months later: 0 10.10
*stock unchanged @ $50 / 50 strike calls
10
WHY LEAPSŪ?
" Advantages
" Lower cost per unit of time
" Less time erosion
" Longer life, more time for a strategy to
work
" Disadvantages
" Higher absolute cost
" Lower sensitivity to change in stock
price
11
LEAPSŪ Strategies
Using LEAPSŪ in a Gifting Program
Using LEAPSŪ in a Gifting Program
" You plan to give $10,000 per
year over the next 3 years to
a relative.
" You want to buy approximately
$30,000 of XYZ stock today.
" Is it possible to use LEAPSŪ
options to target these
objectives?
13
Using LEAPSŪ in a Gifting Program
" XYZ is currently trading at $39
per share
" The XYZ January 2005 LEAPS 30
Call is trading at $14.
" Step 1?
" Step 2?
" Step 3?
14
Using LEAPSŪ in a Gifting Program
" Step 1 - Today
- Deposit $10,000 in recipient s
account
- Buy 7 XYZ January 2005 30
LEAPSŪ Calls at $14 each (Total
Cost $9,800 + comm.)
15
Using LEAPSŪ in a Gifting Program
" Step 2 Next 3 Years
2003 (any month) Deposit $10,000 in
recipient s account
2004 (any month) Deposit $10,000 in
recipient s account
16
Using LEAPSŪ in a Gifting Program
" Step 3 XYZ above $30 in January 2005
-If still bullish on XYZ: exercise calls and
purchase 700 XYZ at $30
-Total cost 700 x $30 = $21,000 + comm.
($20,200 in recipient s account)
-You can sell the calls if you wish. (Taxes?)
17
Using LEAPSŪ in a Gifting Program
" Step 3 XYZ below $30 in Jan 2005
- Calls expire for a total loss of cost
of calls.
- There is still $20,200 in recipient s
account.
18
Investing with LEAPSŪ - Variations
" Buy LEAPSŪ calls for yourself and save
the purchase price of the stock over 2
years.
" Buy LEAPSŪ calls now and pay for the
stock with a year-end bonus.
" Limit the risk of a stock purchase by
buying LEAPSŪ calls and depositing the
sufficient funds in a money market
account. Risk is limited to the cost of
the LEAPSŪ calls.
19
LEAPSŪ Strategies
What Stock Traders Should Know
What Stock Traders Should Know
Option Price Behavior
Stock Price: $51
$50
Days to Exp: 90
90
50 Call: 3.00 ?
21
What Stock Traders Should Know
DELTA: Change in option price
for a one-point change in the
underlying stock price. If the
stock price changes by $1, then
the option price will change by
less than $1.
22
What Stock Traders Should Know
" XYZ trading at $39
" January 2004 LEAPSŪ 30 Call
trading at $13
" What is the delta of this call?
If the stock rises from $39 to $45 in
60 days, what will the call price be?
* All examples do not include commissions and are not intended to be recommendations.
23
What Stock Traders Should Know
" XYZ trading at $39
" January 2004 LEAPSŪ 45 Call
trading at $7
" What is the delta of this call?
If the stock rises from $39 to $45 in
60 days, what will the call price be?
* All examples do not include commissions and are not intended to be recommendations.
24
What Stock Traders Should Know
" When trading LEAPSŪ know the delta.
" Have three exit points in mind:
Profit target
Time limit
Stop-loss point
" Have the discipline to exit the trade
when any of the points is reached.
25
Trading LEAPSŪ vs. Trading Stock
" LEAPSŪ Advantages
Lower Investment
Lower risk
Potentially higher percentage profit
" LEAPSŪ Disadvantages
Lower absolute profit
Potentially larger percentage loss
No dividends, voting rights
26
LEAPSŪ Strategies
Covered Writing with LEAPSŪ
Covered Writing with LEAPSŪ
" Using LEAPSŪ as a stock substitute to
create a position similar to a covered
write (known as a Time-Diagonal spread).
" Example: XYZ @ 49.00 on 8/1/02
Buy 1 XYZ Jan 2004 40 Call @ 14.00
Sell 1 XYZ Sep 2002 55 Call @ 1.65
* Must be done in a margin account.
* All examples do not include commissions and are not intended to be recommendations.
28
Covered Writing with LEAPSŪ 1
At September 02 Option Expiration
Stock Price: $49.00 (unchanged)
Sep 02 55 Call: 1.65 0 +1.65
Jan 04 40 Call: 14.00
?
If S-T call expires, do it again(?)
29
Covered Writing with LEAPSŪ 2
At September 02 Option Expiration
Stock Price: $59.00 (stock up big)
Sep 02 55 Call: 1.65 4.00 -2.35
Jan 04 40 Call: 14.00
?
S-T call is I-T-M! Assigned?
29
Covered Writing with LEAPSŪ 3
At September 02 Option Expiration
Stock Price: $39.00 (stock down big)
Sep 02 55 Call: 1.65 0 +1.65
Jan 04 40 Call: 14.00
?
Stock price decline - stop-loss point?
29
Covered Writing with LEAPSŪ
" Potential profit*= $6.00 in 50 days (8/1 9/20)
" Initial Investment = 12.35 (14.00 1.65)
" Percentage profit* = 48% in 50 days
" Risk limited to initial investment + comm.
" Risk of early assignment on short call
*Profit Potential and Percentage Profit are estimates only, assuming XYZ at $55 or higher
Must be done in a margin account.
30
All examples do not include commissions and are not intended to be recommendations.
Covered Writing with LEAPSŪ
Alternatives if short call is assigned:
Purchase stock and sell another S-T call
Purchase stock and stay long the LEAPSŪ
call
Close entire position by purchasing stock
and selling LEAPSŪ call
Close position by exercising LEAPSŪ call
(not advised if there is time premium in
the LEAPSŪ call)
31
Covered Writing with LEAPSŪ
" What if the stock price declines
significantly?
Will you sell the LEAPSŪ call at a loss?
Will you write another short-term call
with a lower strike price?
Will you keep the LEAPSŪ Call without
selling another short-term call against it?
32
LEAPSŪ Strategies
LEAPSŪ Married Puts
LEAPSŪ Married Puts
Purchase LEAPSŪ puts when
initially acquiring shares
34
LEAPSŪ Married Puts
Purchase put options when initially
acquiring shares
Example:
Stock @ _________________
Buy ____________________
35
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Married Puts
Buy 100 shares ________ @ ________
Purchase one ____________ @ ________
Total investment per share _________
Put exercise price (strike price) _________
Total risk _________
36
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Married Puts
+
Stock
0
Stock with Put
-
37
LEAPSŪ Protective Put
" Already own shares
" Concerned about ? ? ? ?
" Don t wish to sell shares now
" Tax considerations?
" Buy LEAPSŪ Puts as term insurance
38
LEAPSŪ Puts - Pros & Cons
" Protection at a fixed cost
" Flexibility: keep shares and dividends
" Limited cost / limited risk
" Protection can be expensive
" Increases overall cost/breakeven
" Puts expire, stock does not
" Periodic check is essential
39
LEAPSŪ Strategies
The LEAPSŪ Collar
The LEAPSŪ Collar
Collar defined:
Long an O-O-M Put and
short an O-O-M Call
in conjunction with
a long stock position
41
LEAPSŪ Collar for Protection
Long XYZ stock @75
Action:
Buy 70 Put and
Sell 90 Call
42
* All examples do not include commissions and are not intended to be recommendations.
Why Use a LEAPSŪ Collar ?
Collar all of (or part of)
a large stock holding
with LEAPSŪ when
low-cost protection
is desired
43
LEAPSŪ Collar Case Study
You plan to retire in 2005.
You own $750,000 of XYZ.
You cannot afford to let the
value fall below $600,000.
You want some upside.
You can t afford to buy puts.
44
LEAPSŪ Collar Case Study
10,000 XYZ 75.00
Own ________ shares ________ at _________
Buy _________________ puts @ ________
Sell__________________ calls @ ________
Net cost per collar ________
Cost of Hedge ________________________
45
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Collar Case Study
" Minimum value at Jan 05?
" Maximum value at Jan 05?
46
Using a LEAPSŪ Collar 2
You want to buy stock.
You want to limit risk.
You want some upside.
You do not want to pay for insurance!
Collar a stock position with LEAPSŪ
when initially acquiring shares
48
Using a LEAPSŪ Collar 2
Buy 100 shares of XYZ @ $ 75.00
Buy 1 XYZ Jan 05 70 LEAPS put 13.00
Sell 1 XYZ Jan 05 90 LEAPS call 11.60
Net Cost: $76.40
Risk : $ 6.40 (8.5%)
Potential Gain: $13.60 (17.8%)
above example excludes transaction costs
Using a LEAPSŪ Collar 2
+
Stock
0
Stock with Collar
-
Put Strike Call Strike
51
LEAPSŪ Collars - Pros & Cons
" Protection at a reduced cost
" Favorable risk/reward ratio
" Limited upside
" Limited time period
" Risk of early assignment
52
A Year-end (LEAPSŪ) Tax Strategy
You bought a stock and it went down in price
You are thinking of selling it for a tax loss
You are aware of the 30 day before/after rule
(you cannot sell a security for a loss and buy it
within 30 days before or after the date of
sale)
You do not want to Double up with an additional
100 shares 31 days before
You do not want to be out of the market for 31
days
What can you do???
Year-end (LEAPSŪ) Tax
Strategy
Consider the
LEAPSŪ Tax Strategy
Example: Bought 100 shares XYZ at $ 65
Current Price: $ 35
Year-end (LEAPSŪ) Tax
Strategy
" November 25th - buy 1 XYZ Jan 04 30 strike
LEAPSŪ Call at $8.50
" December 27th sell 100 shares of XYZ at $35
" Jan 31st - a choice
Do nothing, control 100 shares with the long
LEAPS call for 12 months with limited risk
Buy 100 shares and sell the LEAPSŪ call, re-
establishing the original position
Year-end (LEAPSŪ) Tax
Strategy
" Advantages:
Realize loss on stock (tax implications?)
Still in the market with minimal outlay and
limited risk
" Disadvantages:
Commission intensive
Amount invested in LEAPSŪ as well as
amount invested in stock at risk for first
31 days
SUMMARY
LEAPSŪ
Wide range of possible uses
Can be a strategic tool for risk management
Can help combat one of the greatest enemies
of options buyers: TIME EROSION
53
Options Industry Council
OIC
THE OPTIONS
1-888-OPTIONS
INDUSTRY COUNCIL
Additional Web Sites:
www.888options.com
www.amex.com
www.cboe.com
www.iseoptions.com
www.pacificex.com
www.phlx.com
PLEASE FILL OUT EVALUATION!
54
Understanding Stock
Understanding Stock
Options
Options
ANSWERS
LEAPSŪ for the
Experienced Trader
LEAPSŪ - Ticker Symbols
Different root ticker symbols
Wal Mart Stock symbol: WMT
Regular Option symbol: WMT
LEAPS Symbols: LWT ZWT
04 05
Microsoft Stock symbol: MSFT
Regular Option symbol: MSQ
LEAPS Symbols: LMF ZMF
04 05
7
LEAPSŪ Time Erosion
3-mo option 2-yr LEAP
8 x 3.40 27
Now: 3.40 11.00
(0.65) or 19 % (0.30) or 3%
1 month later: 2.75 10.70
(0.30) or 3%
(0.85) or 30%
2 months later: 1.90 10.40
(0.30) or 3%
(1.90) or 100%
3 months later: 0 10.10
*stock unchanged @ $50 / 50 strike calls
10
What Stock Traders Should Know
Option Price Behavior
Stock Price: $51
$50
Days to Exp: 90
90
50 Call: 3.00 ?
3.50
21
What Stock Traders Should Know
" XYZ trading at $39
I-T-M Call
" January 2004 LEAPSŪ 30 Call
trading at $13
Delta = .76
" What is the delta of this call?
If the stock rises from $39 to $45 in
60 days, what will the call price be?
Profit +4.30 vs. +6.00
$13 $17.30
?
Cost 13.00 vs. 39.00
* All examples do not include commissions and are not intended to be recommendations.
23
What Stock Traders Should Know
" XYZ trading at $39
O-O-M Call
" January 2004 LEAPSŪ 45 Call
trading at $7
Delta = .52
" What is the delta of this call?
If the stock rises from $39 to $45 in
60 days, what will the call price be?
$7 $9.80 Profit +2.80 vs. +6.00
?
Cost 7.00 vs. 39.00
* All examples do not include commissions and are not intended to be recommendations.
24
Covered Writing with LEAPSŪ 1
At September 02 Option Expiration
Stock Price: $49.00 (unchanged)
Sep 02 55 Call: 1.65 0 +1.65
Jan 04 40 Call: 14.00 13.50 - 0.50
?
Net Profit: +1.15
If S-T call expires, do it again(?)
29
Covered Writing with LEAPSŪ 2
At September 02 Option Expiration
Stock Price: $59.00 (stock up big)
Sep 02 55 Call: 1.65 4.00 -2.35
Jan 04 40 Call: 14.00 21.75 +7.75
?
Net Profit: +5.40
S-T call is I-T-M! Assigned?
29
Covered Writing with LEAPSŪ 3
At September 02 Option Expiration
Stock Price: $39.00 (stock down big)
Sep 02 55 Call: 1.65 0 +1.65
6.75 - 7.25
Jan 04 40 Call: 14.00
?
Net Loss: - 5.60
Stock price decline - stop-loss point?
29
LEAPSŪ Married Puts
Purchase LEAPSŪ puts when
initially acquiring shares
Limits risk during life of the put
Unlimited profit potential
(less cost of puts)
34
LEAPSŪ Married Puts
Purchase put options when initially
acquiring shares
Example:
HD @ 30.00 on 7/31/02
Stock @ _________________
HD Jan 04 30 Put @ 5.25
Buy ____________________
35
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Married Puts
HD 30.00
Buy 100 shares ________ @ ________
Jan 04 30 Put 5.25
Purchase one ____________ @ ________
35.25
Total investment per share _________
30.00
Put exercise price (strike price) _________
5.25
Total risk _________
15% risk in 18 months
Profit potential unlimited
36
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Collar Case Study
10,000 XYZ 75.00
Own ________ shares ________ at _________
Protecting only 8,700 shares.
87 Jan 05 70 13.00
Buy _________________ puts @ ________
90 Jan 05 90 11.60
Sell__________________ calls @ ________
1.40
Net cost per collar ________
87 x $140 - $3480 = $8700
Cost of Hedge ________________________
45
* All examples do not include commissions and are not intended to be recommendations.
LEAPSŪ Collar Case Study
" Minimum value at Jan 05?
Exercise puts sell 8,700 XYZ @ $70
8,700 x $70 = $609,000 less comm.
" Maximum value at Jan 05?
Calls assigned sell 9,000 XYZ @ $90
9,000 x $90 = $810,000 less comm.
Plus value of other 1,300 shares
46
Using a LEAPSŪ Collar 2
Buy 100 shares of XYZ @ $ 75.00
Buy 1 XYZ Jan 05 70 LEAPS put 13.00
Sell 1 XYZ Jan 05 90 LEAPS call 11.60
Net Cost: $76.40
Risk : $ 6.40 (8.5%)
Potential Gain: $13.60 (17.8%)
above example excludes transaction costs
Year-end (LEAPSŪ) Tax
Strategy
Consider the
Thanksgiving - Christmas - Super Bowl
LEAPSŪ Tax Strategy
Example: Bought 100 shares XYZ at $ 65
Current Price: $ 35
Year-end (LEAPSŪ) Tax
Strategy
" November 25th - buy 1 XYZ Jan 04 30 strike
LEAPSŪ Call at $8.50 (Thanksgiving)
" December 27th sell 100 shares of XYZ at $35
(Christmas)
" Jan 31st - a choice
Do nothing, control 100 shares with the long
LEAPS call for 12 months with limited risk
Buy 100 shares and sell the LEAPSŪ call, re-
establishing the original position (Super Bowl)
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