The ability to spend less, yet to capture more is a value proposition that is difficult to pass up. Investors with strong convictions that a company is undervalued may wish to consider investing in a type of long-term call option series called LEAPS®, or Long-term Equity Anticipation Securities. LEAPS® are long-term stock (or index) options that expire more than 9 months away and can often endure as long as 2-3 years.
By opening a LEAPS® call option position, an investor with the foresight to taken on significant risk, can purchase this right to buy 100 shares of the underlying company at a fraction of the cost that would otherwise be attributed to actually buying all 100 shares. As the share price appreciates, so does this right that the investor owns. The following is an example of how this works (absent of commissions often associated):
- The current price of CompanyXYZ on January 28, 2012 is $15/sh.
- Jack buys one Jan14 CompanyXYZ $20 Call option at $1.10/sh for $110. Jack is buying the rights to buy 100 shares of CompanyXYZ at $20/share until January 2014. For these rights, he is spending $110.
- Jill buys 100 shares of CompanyXYZ stock at $15/sh. For these shares she spends $1500.
- On March 20, 2013, the current share price of CompanyXYZ is now $25/sh.
- Jack decides to close his LEAPS® Call option which is now trading at $9.50/sh. He sells his Call option and receives $950.
- Jill sells her 100 shares of stock at $25/sh. for $2500.
By utilizing an out-of-money call option (an option with a strike price higher than the current price) rather than buying the underlying stock itself, an investor is able to capture a significant portion of the upside potential with an accelerated rate of return at a reduced cost. Likewise, the call holder has a defined amount of loss potential ($110) that is significantly smaller than actually holding onto the company's stock ($1500). Jack is also able to sell his option at an earlier date than having to actually hold onto the right until January 2014.
However, there are several significant consequences to this kind of transaction. The first, that should be emphasized, is that options are by nature much more volatile than stocks. As in any leveraged scenario, were the underlying company to decline in value, Jack would experience a similar decline at an accelerated rate. If by January 2014, the share price of CompanyXYZ is not at least $21.11/share, Jack's call option becomes worthless.
Due to the time decay, the call option will continue to lose value even if the underlying stock price were to stay the same throughout the duration of the option. This rate of valuation decay is significantly less under a LEAPS® option due to the long duration of the option. Last of all, as Jack is invested in the call option, and not the underlying stock itself, Jack does not profit from any dividends or distributions issued by the company. Quite contrary, the issuance of a dividend results in a loss of equal share value which affects the value of the held call option negatively.
Investors with strong convictions of a price recovery within a 1-2 year time frame may consider using this options strategy as a means to gain exposure, limit loss potential, and accelerate returns. Unfortunately not all companies have LEAPS® available to them. Companies that tend to be more popular tend to do so, while less popular small-cap companies often do not.
Companies that are currently trading under book value due to extraordinary circumstances can often be the ideal candidate for opening a long-term call option. While there is significant risk, the theory is that they have more upside potential bound to them once their markets recover (should they ever do so). The following list compiles a few companies currently trading under they book values that have LEAPS® available to investors. All companies should be researched more thoroughly prior to investment in order to match suitability to the investor's goals. All values were taken as of 1/28/2012.
|Company Name||Forward P/E||Last Price||Book Value||Industry|
|DryShips (DRYS)||4.09||$2.21||$7.87||Dry Bulk Shipping|
|Lincoln National (LNC)||5.31||$20.98||$49.46||Insurance|
|Canadian Solar (CSIQ)||n/a||$3.92||$11.98||Solar Panels|
|Arcelor Mittal (MT)||9.46||$21.75||$38.47||Steel|
|Royal Carribean Cruises (RCL)||9.29||$27.69||$38.85||Cruise Vacations|
|Deutsche Bank AG (DB)||7.36||$44.44||$75.62||Financial Services|