LEAPS: Options for the Long Term - Part 5
...continued from Part 4
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.
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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.
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