As we all know by now, May was a terrible month for equities. The Dow Jones Industrial Average is now negative on the year and the S&P 500 is hanging on by a thread. We have seen key technical levels broken amidst more Euro fears, while patiently awaiting the outcomes of both the Federal Reserve and Greek elections. As a matter of fact, I have felt as though the sell off has been rather orderly. However, though a bottom may not be in place, and prices may continue to diminish, now may be as good of time as any to start scooping up names on the cheap. Microsoft (MSFT) and Qualcomm (QCOM) have gotten sold off along with almost all other names in recent weeks, but it may be time to take a look.
Recently I wrote an article on both Microsoft and Qualcomm and why I thought they were good purchases (click the link to see a more in depth analysis on each company). Microsoft has essentially stayed flat, while Qualcomm has gotten a bit cheaper since I first wrote about it on May 25th, but has found solid support at the $55 level. Now I would like to write about how I would play both of these names, by using long term options, or LEAPs.
Above: Six-month chart of MSFT (click to enlarge. Courtesy of Stockcharts.com).
As you can see in the chart above, Microsoft is holding their 200-day simple moving average very well. Fundamentally, Microsoft is a very solid company, with a fairly decent dividend yield of 2.8%. The trade that I am looking for in Microsoft is using long term call options. Below I will display the trade as well as provide a summary afterwards.
Buy 1 January 2013 29 Call @ 2.12
Days until expiration: 228 days
Net debit (max risk): $212
Since equities are clearly stuck in a rut, long term option plays may be our best when looking for return, especially at a fraction of the cost compared to purchasing the stock outright. Basically what this trade allows is for us to purchase one options contract (which represents 100 shares) for $212. This option will not expire until January of 2013, which allows over seven months for Microsoft to complete our intended move. With a closing price of $28.55, this option is slightly out of the money by $.45. We are looking for Microsoft to close over $31.12 by January expiration.
Above: Six-month chart of QCOM (click to enlarge. Courtesy of Stockcharts.com).
The chart above may look like a broken stock, but rest assured, Qualcomm is not a broken company. With a breakdown at their 200-day simple moving average, Qualcomm is now finding significant support at $55. Qualcomm fails to provide a significant dividend yield, so owning the option contracts over the actual stock, could be much more beneficial to certain investors. Again, I will display the trade, followed by a summary.
Buy 1 January 2013 57.5 call @ 5.00
Days until expiration: 228 days
Net debit (max risk): $500
This is much like the first trade, in terms of expiration and being slightly out-the-money. However, since the share price is much higher, so is the options contract. For this one, we are paying $500 to purchase the 57.5 contract, while the stock currently trades for $55.85. What we are expecting to see is Qualcomm closing over 62.5 by the time January expiration comes around.
I personally prefer to select slightly out-the-money or at-the-money option contracts for impending stock moves over long periods of time. While using deep in-the-money option contracts allows for one to have a higher delta, I think when looking out as far as six or more months, the risk for unexpected news is far greater. Delta is the measurement of how much the option contract will move as the underlying stock moves. So for instance, a delta of 50 implies that for every $1 increase or decrease in the actual stock price, the option contract will increase or decrease in the same direction by $.50. The delta of the option contract will change depending on how far in either direction (up or down) the stock continues to move in.
Since both contracts are out-the-money they will initially participate less in the movement of the underlying stock. That's okay. If these names can find their way back to levels we saw just a few weeks ago, these options contracts will be worth far more than they are now. Also, by using LEAPs contracts that are slightly out-the-money, we are able to put down much less money to participate in the share price movements. If one were to initiate this trade, and only purchase one option for each name, they would have a maximum risk of $712, but control $8440 in underlying stock.
While it is no guarantee that Microsoft and Qualcomm will find their earlier levels from 2012, they are both great companies, fundamentally, and will likely rebound soon. I think owning LEAPs over the actual stock may be beneficial to many, especially with all the European headwinds and economic slowdowns currently weighing on the equity markets. However, with plenty of time in both options, we will have a very large window to hit our expected moves. Also, by using far dated options, time decay plays a very little role in our returns, for now. I think U.S equities will rebound, at some point this year, and these names will see that rebound too.