The contingent purchase strategy is a way of investing in a security without the risk of outright ownership. For an expensive stock like Apple (AAPL), the contingent purchase can offer an investor a way of accruing the capital required to buy the stock over time at today’s prices; kind of like putting your stock on “layaway.”
con·tin·gent [kuh’n-tin-juh’nt] adj.
1. Likely but not certain to happen. 2. Intended for use in circumstances not completely foreseen. (Merriam-Webster's Dictionary of Law. Merriam-Webster, Inc.)
It sounds strange to use the word “contingent” with “strategy,” but using options to leverage capital with the intention of acquiring stock can be worthwhile when the market is volatile and the price of a security has recently fallen. If an investor doesn’t want to risk his capital on a stock that may continue to fall, he can realize a buying opportunity by purchasing a Long-term Equity AnticiPation Security (LEAPS) option at a favorable strike price. Using LEAPS puts time on the investor’s side which is especially important if employing a contingent strategy with long calls.
There are a few conditions to consider when implementing the contingent purchase strategy:
1. Market conditions are volatile. Prices may be going up and down as part of an upward or downward trend or just whipsawing sideways. The price of a stock has come down to a level that makes it an attractive purchase opportunity for the investor.
2. The investor is bullish long term but uncertain of the short term outlook. The dilemma facing the investor is a stock that can continue to whipsaw or take-off and leave the buying opportunity behind.
3. The stock is intended to be a long-term investment. Therefore, the investor has to have the capital required to exercise the option at the strike price purchased. If one uses a long time horizon with LEAPS options, the investor has time to save up the required capital if necessary.
Apple is an interesting case because it’s widely regarded as a stock that can continue its phenomenal growth long term, but has plenty of short-term bears to make a case for price reduction. Let’s take a look at how one might employ the contingent purchase strategy with Apple.
As of this writing, Apple is trading at $381. It’s attractively valued with a P/E of 13.9, a forward P/E of 9.9 and a PEG ratio of 0.75. Analysts place a price target on Apple in the range of $500-$515. The new iPhone 4S is selling out at many stores and the iPad seems to be fending off new tablet competitors such as the Kindle Fire in media reviews. But recently, Apple reported an earnings miss and the stock has been trading in the $380-$410 range ever since. Apple is testing trendline support in the upper $370s and if it falls through, then it may begin to test its 200-day moving average in the lower $360s.
If you like Apple as a stock but don’t like the volatility, or you simply don’t have the capital to purchase 100 shares, then take a look at Apple LEAPS options. Choose a strike price on a Jan 2014 LEAPS option that seems appropriate. For the strategy to be profitable, you need the stock to increase in market value equal to or greater than the investment level. For example, if you purchased a Jan 2014 380 AAPL call at $90.00, the stock would need to rise to $470 per share before your breakeven point (not counting transaction fees).
There are two ways to reduce the risk of the contingent purchase strategy.
- Choose a higher strike price to lower the premium. The initial outlay in premium is reduced by choosing a higher strike price but the stock will have to realize a higher gain to breakeven.
- Sell shorter term call options to offset the premium. The long call option covers the near-term short call option in the event the near-term option is exercised. The investor wants to have the short option expire worthless so he can perhaps sell another call option to offset more of the premium spent on the long option. This would also have the effect of lowering the breakeven point.
Long Jan 2014 AAPL 380 Call: $90.00
Breakeven price: $380+$90 = $470
Short Dec 17 AAPL 415 Call: $2.90
New Breakeven price: $470-$2.90 = $467.10
So how does this strategy limit risk? Say you spend $9000 on Apple call premium and the stock loses 50 points. You could not lose more than your $9000 investment and in this case your call option would still be worth approximately $6800, leaving you with a loss of $2200. If you had purchased 100 shares of Apple stock on the market, that 50 point loss would translate to a $5000 loss. This limitation of risk is the reason why someone enters into a contingent purchase strategy.
It’s also worth mentioning that this strategy works best when diversifying among several pre-screened stocks that one wants to own long term and with call options that are widely traded. If only some of those stocks increase in value, exercise the calls on the profitable positions and either close the losers or wait until they do become profitable. This strategy can also be used to fix the price of additional shares of stock you already own. The purchase of LEAPS options gives the investor time and flexibility for the market to move in his favor.
In conclusion, the contingent purchase strategy is a way to reduce the risk of purchasing a stock in a volatile market, while preserving the opportunity to buy the stock at a favorable price in the event of strong appreciation. This article is not a recommendation to purchase shares of Apple, but is simply an illustration of how the contingent purchase strategy can be used during an uncertain market.