The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices. This strategy is often compared to purchasing insurance on one's home or car, and may give investors the confidence to remain in the market. The amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost, should be considered.
For example, ZYX is trading at 45 and a ZYX LEAPS put with a three-year expiration and a strike price of 42.5 is selling for 3.5 or $350 per contract. These puts provide protection against any price decline below the break-even point, which for this strategy is 39 (strike price less the premium). The investor's risk or maximum loss is limited to the total amount paid for the put options or $350 per contract. The following are possible outcomes of this strategy at expiration.
Stock above the break-even point
If ZYX is trading at 48 at expiration, the unexercised put would generally expire worthless, representing a loss of the option premium or $350 per contract.
Stock below the strike price
The put would be profitable if the stock closed below 39 at expiration. If ZYX is trading at 37.5 at expiration, the 42.5 put, upon exercise, would have a value of 5 or $500, representing a profit of 1.5 points or $150 per contract. This profit will partially offset the decline in the value of the stock.
Stock between the strike price and the break-even point
If ZYX is trading at 41.5 at expiration, the 42.5 put would be valued at approximately 1. This means that, upon exercise, a portion of the option premium would be retained and the loss would then be 2.5 points or $250 per contract. If the contract is not exercised or sold, the investor will lose all of the initial investment, or $350 per contract.
Sell LEAPS Covered Calls
The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.
The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.
Investors should be aware of the risks involved in a covered call strategy. Call writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price. The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.
The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS call. ZYX is currently trading at 39.5, and a ZYX LEAPS call option with a two-year expiration and a strike price of 45 is trading at 3.25.
An investor owns 500 shares of ZYX at $39.5 per share and sells five of ZYX LEAPS calls with a strike price of 45 at 3.25 each or a total of $1,625. The investor's objective is to obtain profits without selling the stock. The break-even point for this covered call strategy is 36.25 (the stock price of 39.5 less the premium received of 3.25). This represents downside protection of 3.25 points. A loss will be incurred if ZYX declines to below 36.25. Possible outcomes of this strategy at expiration are as follows.
Stock above the strike price
If ZYX advances to 50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of 45 less the price of the stock when the option was sold plus the option premium received of 3.25 X 100).
Stock below the break-even point
If ZYX is trading at 34 at expiration, the unexercised LEAPS calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.
Stock between the strike price and the break-even point
If ZYX advances to 40 at expiration, the LEAPS calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of 3.25 per share.
Unit of Trade: Generally 100 shares of stock per unadjusted contract.
Premium (Price) Quotations: Stated in points and fractions; one point equals $100. The minimum price change for series trading below 3 is .05 ($5) and for all other series is .10 ($10) per contract.
Exercise: Equity LEAPS are American-style options. The option may be exercised prior to the expiration date.
Exercise Settlement: A holder that tenders an exercise notice on any business day will receive delivery of the underlying stock on the fifth business day following the date of exercise. The exercise settlement price equals the strike price multiplied by 100 (multiplier) for unadjusted series.
Expiration Cycle: Equity LEAPS expire in January of each year.
Expiration Date: Expiration occurs on the Saturday following the third Friday of the expiration month.
Position Limits: LEAPS positions are aggregated with other options with the same underlying asset. Limits vary according to the number of outstanding shares and trading volume. Hedge exemptions may be available. Contact exchanges for details.
Trading System: Market Maker/Designated Primary Market Maker/Lead Market Maker/Specialist/Registered Option Trader (depending on the exchange).
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