An investor anticipates that the price of ZYX stock will rise during the next two years. This investor wants to profit from the increase without purchasing shares of ZYX.
The following are possible outcomes of this strategy at expiration.
If ZYX advances to $65 at expiration, the LEAPS® calls have a value of approximately $15 (the stock price of $65 less the strike price of $50). The investor can exercise the calls and take delivery of the stock at a price of $50 per share, or sell the LEAPS® calls for a profit.
If ZYX, at expiration, is trading for less than the strike price, or below $50 in this example, the unexercised calls expire worthless. In this case, the investor incurs the maximum loss of $4,250.
If ZYX is at $56 at expiration, the calls will be valued at approximately $6 (the stock price of $56 less the strike price of $50). This represents a partial loss given the break-even point of $58.50. Upon exercise, the calls purchased by the investor for $8.50 will then be worth approximately $6, creating a loss of $2.50 or $250 per contract. If the investor does not exercise or sell these options, the investor loses 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 is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration. Time value is a component of an option premium, and it generally decreases as expiration approaches.
The purchase of LEAPS® puts to hedge a stock position may provide investors protection against declines in stock prices. Professionals often compare this strategy to purchasing insurance on one’s home or car. This may give investors’ confidence to remain in the market. Investors should consider the amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock’s cost.
For example, ZYX is trading at $45. A ZYX LEAPS® put with nearly three years until expiration and a strike price of $42.50 is selling for $3.50 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:
If ZYX is trading at $48 at expiration, the unexercised put generally expires worthless. This represents a loss of the option premium or $350 per contract.
The put is profitable if the stock closes below 39 at expiration. If ZYX were trading at $37.50 at expiration, the $42.50 put has a value of $5 or $500 upon exercise. This represents a profit of $1.50 or $150 per contract.
If ZYX is trading at $41.50 at expiration, the $42.50 put would be valued at approximately $1. This means that an investor would retain a portion of the option premium and the loss would then be $2.50 points or $250 per contract upon exercise. If the investor does not exercise or sell the contract, they lose all of the initial investment, or $350 per contract.
The covered call is a widely used, conservative options strategy. It requires selling (writing) a call against stock. Investors utilize this strategy to increase return on the underlying stock and provide a limited amount of downside protection.
The maximum profit from an out-of-the-money covered call is realized when the stock price is at or above the strike price at expiration. 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 benefit from any increase in the stock above the strike price (plus the premium received) since they are obligated to sell the stock at the call’s strike price upon assignment. 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 begins 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 $39.50. 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 $39.50 per share and sells five 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 at expiration is $36.25 (the stock price of $39.50 less the premium received of $3.25). This represents downside protection of $3.25 points. An investor incurs a loss if ZYX declines below $36.25 at expiration. Possible outcomes of this strategy at expiration are as follows:
If ZYX advances to $50 at expiration, the covered call writer, upon assignment, obtains 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).
If ZYX is trading at $34 at expiration, the unexercised LEAPS® calls generally expires worthless. The unassigned covered call writer has a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). The investor incurs additional losses in their stock position if ZYX continues to decline in value.
If ZYX advances to $40 at expiration, the LEAPS® calls are out-of-the-money. Therefore, the probability of assignment for the call writer is minimal. The investor retains the 500 shares of ZYX and the option premium of $3.25 per share.
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