For traders that are highly bullish on a stock, a deep in-the-money LEAP option provides them an ability to leverage a stock position and take advantage of a long-term options expiration. This trade is best reserved for trades where the investor may believe that the stock is going to move much higher and the risk of downward price movement is remote.
Investors of American International Group's (AIG) common stock know that AIG is nearly free of their government ownership. With the Treasury stake in the company likely to wind-down this year, a proper valuation for the fully private institution seems to be based on fundamentals and not political outcomes. Currently, AIG trades for 0.59 price to book value with the stock trading over $35 per share. Simple math shows that book value per share is actually closer to $60 per share. So, an investor may choose a price target of $60 when making an investment decision over this stock.
January 2014 LEAP contracts expire in about 15 months. So, buying a $18 AIG January 2014 LEAP contract could be a good way to double your exposure to a stock that may very well double in the next year. The $18 LEAP contract has an ask price of $19.05. This means the intrinsic value of the option contract is $17.45 and the time value of the contract is only $1.60. If the stock rises to book value of $60 per share, purchasing the LEAP option will generate a $22.95 profit on an investment of $19.05, a 120.5% return on your investment. Simply purchasing the stock at $35.45 would generate a profit of $24.55, a 69.25% return on your investment. The difference in return on investment for the trade is 51.22%.
Just as leverage can boost your overall return on the upside, it can also erode your investment at a rapid pace if the stock were to fall. If AIG stock falls to $25.92, half of the LEAP contract investment would be erased. Whereas, an investment in the common stock would lose half it's value when the stock drops to $17.73. Leverage works both ways to amplify returns and losses.
Peter Lynch gave several rules for investing and one of his rules was "Whatever the queen is selling, buy it." In this case, the Treasury is selling AIG stock. The Queen refers to the government. The Treasury has no interest in seeing AIG shares fall just after they unload their last bit of the investment. The time to buy is now.