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business newsUsing LEAPS to Lock In Profits
LEAPS for collars can provide greatly reduced risk while still allowing for upside profit potential.
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LEAPS are options issued with January expiration periods, and they have initial life spans exceeding one year. Most stocks will have two LEAPS years (that currently means January 2011 and January 2012) available for trading.
One advantage of LEAPS over shorter-term options is that time decay has a negligible affect on their value. LEAPS' advantages over ownership of the underlying shares include lower cost and reduced volatility.
While they can be used in the replacement strategy discussed in Consider Replacing Your Best Performing Stocks, they also can be used to lock in gains or to limit the risk in volatile stocks by establishing a collar. A collar is the simultaneous purchase of a put and sale of a call with the same expiration but different strike prices done in conjunction with a long stock position. An example construction would be buying (or already owning) 1,000 shares of XYZ at $100, buying 10 January $90 puts and selling 10 January $110 calls.
Typically, one looks for the sale price of the call equal to the purchase price of the put, making it a no-cost collar. In the example above, this would essentially lock in a sale of XYZ at a price no lower than $90 and no higher than $110 per share. In this case, as would be with most short-dated options, the risk is equal to the reward.
The advantage of using LEAPS for collars is that they can provide greatly reduced risk while still allowing for upside profit potential -- because stocks have an upward bias, most option pricing models (Black-Scholes, for example) will award a long-term out-of-the-money call a greater value than the corresponding put. This creates a situation in which the higher the volatility and the longer the time horizon, the greater the difference in the strike prices in which the call and the put will have the same price.Let’s revisit the Apple (AAPL) example I used in Consider Replacing Your Best Performing Stocks. With it still trading around $235 a share, one can go out to the 2011 LEAPS and sell the $260 call for around $19 a contract and buy the $220 put for around $220 a contract. This would give you $25 or 10% of additional upside while limiting losses to just $15 or 6.2% over the next 10 months. This compares to using the July options, where the sale of the $260 call would garner just $6 while the cost of the put would be $8 a contract, or a net debit of $2 for the collar.
It should be noted that on dividend-paying stocks the price skew between puts and calls is reversed; meaning that the puts will have a higher value to reflect the dividend payments. For example, in McDonald’s (MCD), whose shares are trading around $67 with a dividend yield of 3.3%, annually the January $75 calls with a 2011 expiration are trading around $1.20 while the corresponding $60 puts carry a $3.50 price tag. So if you're using collars to hold on to dividend-paying stocks to maintain an income stream be aware the it will have a different price structure.
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