Most retail option investors are buyers, rather than sellers, and the majority of these buyers prefer short-term expirations as opposed to longer-term options. This squares with Americans’ lust for instant gratification. Who wants to wait months or years for results when you might be able to profit quickly?
Long-term Equity Anticipation, or LEAP options, are actually contracts which grant their owners rights to buy or sell stock at a fixed price - through the set expiration date. Writers (sellers) of LEAPs must stand ready to deliver shares (if calls were sold) or to buy shares (if puts were written) at any time from the date of sale up to the expiration date of the LEAP contract.
LEAPs are the same as other options but their expiration dates are further out in the future. Not every company has LEAP options available. Some LEAPs now have expiration dates that may extend as far out as January 2012.
When you sell a LEAP option you will receive more in per-share option premium than you would if you sold a shorter-term option. Selling LEAP puts reduces your risk by lowering your net purchase price on an absolute basis (should you be ‘put’ the shares) and it increases your potential gain (over short-term put sales) because your maximum profit in either case is the money you receive when you sell the option. If the options expire worthless you keep the premium received and your obligation to buy disappears.
Lowe's (LOW) is the second-largest home-improvement retailer in the world and operates approximately 1,700 warehouse-format stores throughout the United States, Canada, and Mexico. The company's stores offer products and services for home decorating, maintenance, repair, and remodeling. Lowe's targets retail do-it-yourself and do-it-for-me customers, as well as commercial business clients.
It’s no secret that housing related businesses have suffered more than most due to the real estate price declines. Lowe’s EPS peaked at $1.99 in 2006 and will likely bottom at about $1.20 in the FY ending January 31, 2010.
While nobody knows exactly when housing prices will pick up, it seems unlikely that Lowe’s will not have much higher earnings 2 - 3 years from now than they do today. Value Line sees a rebound to $2.05 /share by 2012 – 2014. LOW’s 10-year median P/E looking backwards has been 20x. Value Line is using a 19 multiple in computing their 3 – 5 year estimate for LOW’s share price. Even in the depressed housing/real estate environment of 2008 Lowe’s shares averaged a 15.1 P/E.
If you think FY 2011 (ends Jan. 2012) EPS will come in at only $1.60 and apply a very conservative 16 multiple you arrive at a target price of $25.60 by early 2012.
That is a very low-ball estimate for a company that will likely be showing decent growth by then as the housing market starts its recovery. LOW shares hit peak prices of $25 - $35.70 in each calendar year 2002-2008. They traded close to $24 last month.
It’s a high-quality company. Value Line rates their financial strength as ‘A+’ while noting their safety as ‘above average’ and their ‘stock price stability’ and ‘earnings predictability’ in the 80th percentiles (with 100th being best). Morningstar gives LOW their highest, 5-Star rating, and sees ‘fair value’ as $36 /share.
Lowe’s has raised its dividend each year since 2002 and the $0.09 quarterly payout represents a current yield (at Tuesday’s close of $21.07) of 1.71%. It looks quite secure at just 30% of this year’s expected earnings.
Lowe’s management has stated their intention to repurchase up to $15 billion in stock over the next few years which should be accretive to EPS between now and 2012.
Here’s the trade I did for my own account.
Sell 10 LOW Jan. 2012 $25 Puts @ $7 /share
Net Cost / Share (if Exercised)
Approximate Initial Margin Requirement*
Approx. Maintenance Margin Requirement
* Margin requirements may vary by brokerage firm
These requirment amounts are in addition to the put premium received.
If I’m correct in my assumption that Lowe’s shares will be above $25 by expiration date in January 2012, then these puts will expire worthless. That would result in a best-case scenario $7,000 net gain (less commission) without my ever having to have bought the shares at all.
In a worst-case scenario where LOW shares remain below $25 on expiration date:
- The $25 put will be exercised.
- I will be forced to buy 1000 shares of LOW.
- I will need to lay out $25,000 in cash.
- I will end up with 1000 shares of LOW at a net cost of $18 /share.
If my $1.60 /share in earnings has materialized by then my projected P/E at that $18 net price would be just 11.25x. Even without any dividend increase my yield would be 2.0%. I would be more than willing to own 1000 shares of LOW if I can get it for $18 per share.
By selling LEAP puts at a $25 strike price and a 2012 expiration for a $7 premium I am committing to buy LOW shares at a net cost of $18 if the buyer of the option exercises his option.
- If LOW finishes above $25 on expiration date (and the LEAPS were not used early) I will show a gain of $7,000.
- If LOW shares are unchanged from their $21.07 close of Sep. 22, 2009 on expiration date (or at the time of any early exercise) I could liquidate for a profit of $3,070.
- If LOW shares declined by up to $3.07 or (-14.5%) from their initial $21.07 price I would not suffer any loss.
For me, this is a great use of LEAP options. It gives the housing market time to rebound, I have a great chance at a $7,000 profit and I have a margin of safety of almost 15% if my assumptions prove incorrect.
If I leave this position alone until expiration date in 2012 and the puts expire or are closed for a profit the gain will become taxable as a 2012 transaction.
I will need to report the trade on my 2012 tax year Schedule D in April of 2013. While the $7,000 in cash hit my account today my tax liability (if everything goes as I expect) will be deferred until April 2013.
NOTE: If you write the puts against marginable securities already held in the same margin-type account you can avoid the need to tie up any cash at all (unless and until the puts are actually exercised).
Disclosure: Author is short the 2012 $25 puts as described.