Options Guide

Strategies

Buy LEAPS® Calls

An investor anticipates that the price of ZYX stock will rise during the next two years. This investor would like to profit from the increase without having to purchase shares of ZYX.

ZYX is currently trading at 50½ and a ZYX LEAPS® call option, with a two-year expiration and a strike price of 50, is trading for a premium of 8½ or $850 per contract. The investor buys five contracts for a total cost of $4,250, which represents the total risk of the call position. The calls give the investor the right to buy 500 shares of ZYX between now and expiration at $50 per share regardless of how high the price of the stock rises. To be profitable, though, at expiration, the stock must be trading for more than 58½, the total of the option premium (8½) and the strike price of 50. The buyer's maximum loss from this strategy is equal to the total cost of the options or $4,250. The break-even point for this strategy is 58½.

The following are possible outcomes of this strategy at expiration.

Stock above the break-even point
If ZYX advances to 65 at expiration, the LEAPS® will have a value of approximately 15 (the stock price of 65 less the strike price of 50). The investor may choose to exercise the calls and take delivery of the stock at a price of 50, or may sell the LEAPS® calls for a profit.

Stock below the strike price
If ZYX, at expiration, is trading for less than the strike price, or below 50 in this example, the unexercised calls will expire worthless. In this case, the investor will incur the maximum loss of $4,250.

Stock between the strike price and the break-even point
If ZYX, at expiration, has risen to 56, the calls will be valued at approximately 6 (the stock price of 56 less the strike price of 50) and will represent a partial loss given the break-even point of 58½. The calls purchased by the investor for 8½ will, upon exercise, then be worth approximately 6, creating a loss of 2½ points or $250 per contract. If the investor does not exercise or sell these options, the investor will lose all of the initial investment, or $850 per contract.

Prior to expiration, the LEAPS® may trade at a price that is somewhat higher than the difference between the 50 strike price and the actual stock price. This difference is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration. Time value is one of the components of an option premium and generally decreases as expiration approaches.

Buy LEAPS® Puts

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 42½ is selling for 3½ 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 37½ at expiration, the 42½ put, upon exercise, would have a value of 5 or $500, representing a profit of 1½ 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 41½ at expiration, the 42½ 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 2½ 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.

The 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 39½, and a ZYX LEAPS® call option with a two-year expiration and a strike price of 45 is trading at 3¼.

An investor owns 500 shares of ZYX at $39½ per share and sells five of ZYX LEAPS® calls with a strike price of 45 at 3¼ 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 36¼ (the stock price of 39½ less the premium received of 3¼). This represents downside protection of 3¼ points. A loss will be incurred if ZYX declines to below 36¼. 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 3¼ 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 3¼ per share.

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