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Camille Shirley
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I grew up in rural Alabama with my family teaching that our main investment should be land. Over time I have expanded my horizons and have started following dividends and long-term investments.
  • Supercharge Blue Chip Investing With LEAPS 3 comments
    Mar 24, 2014 5:53 PM | about stocks: XOM, F, GM, CSCO, CVX, COP

    Recently while reading an analysis of Exxon Mobile, (NYSE:XOM) a commenter mentioned the use of deep in the money LEAPS and that he was investing in Exxon through these financial instruments. It gave me the idea of creating a blue chip portfolio of LEAPS that offers an investor a speculative but highly profitable way to invest in blue chip, dividend growing companies.

    The Plan:

    • Find high quality blue chip companies that are undervalue relative to their Morningstar Fair Values.
    • Screen out those companies who have 2015 price targets below the Fair Value price, (thus leaving just stocks projected to climb even higher than Fair Value).
    • Buy deep in the money LEAPS expiring Jan 15, 2016.
    • Wait patiently until Jan 2016 and sell LEAPS, hopefully at a large profit.

    The Logic:

    First of all, to those investors new to options investing, I'll quickly explain what a LEAP is and why I believe this idea will work.

    LEAPS stand for Long-Term Equity Anticipation Security. Its a long-term call option.

    Call options are a contract that gives the owner the right to, (but not obligation) to purchase a stock for a particular "strike price" by a certain date. Each contract is for 100 shares.

    The benefit of options is that they are a form of leveraged investment. Each contract controls 100 shares of an underlying equity for a fraction of the cost of 100 shares. The amount of leverage is dependent on how much time is left on the option and how deep in or out of the money the option is.

    In or out of the money simply refers to the price of the stock relative to the strike price of the option. The strike price is the price of stock mentioned in the option.

    For example, a Cisco (NASDAQ:CSCO) $20 call option is $5 in the money, if Cisco is trading at $25. Any call options that are for strike prices higher than the stock price are out of the money and consisting entirely of "time value". This is the value the market places on the option because the stock has time to increase above the strike price.

    If a call option is in the money than it has "intrinsic value" which is the stock price-strike price. The remaining value of the option is the time value, which decays over time until it hits 0 at the expiration date.

    For example, if a Microsoft $30 2016 LEAP is trading at $15 and the stock is at $40, then the intrinsic value is $40-$30=$10 and the remaining $5 is time value. If the price were to remain the same over 2 years the time value will decay to $0.

    So now I turn to this idea of a blue chip deep in the money LEAPS and the risks and rewards.

    First the risks:

    • Call options are speculative because you don't own anything nor collect dividends.
    • The capital gains that can be derived are based on both the price of the stock and timing.

    For example, if you buy a $20 call on a $40 stock and that stock goes to $60 within 2 years then you make a bundle. However, if the market corrects for whatever reason, right before the option expires then you stand to lose a great portion of your gains or even incur a loss if the price drop is severe enough.

    • Call options utilize leverage which is always a two edged sword. Greater gains on the upside, greater losses on the downside.


    • The leverage used through options is cheaper than borrowing on margin and paying the broker interest.
    • The leverage used can be much higher than any broker would allow. For example, the average leverage for the experimental portfolio is 3.58x. This is far higher than could safely be attempted by purchasing stock on margin at a broker.
    • Because I'm looking at deep in the money call options there is very little time value, or "premium". This greatly minimizes the risk of losing money in the future, compared to at the money or out of the money options. Those options will lose value over time if the stock stands still. Deep in the money options have very little time value and so will retain their value.
    • Rising interest rates, which will increase the cost of buying on margin, don't effect this system.

    Ok, so new investors may still be a bit confused as to what exactly I am talking about so I will use a specific example from my experimental portfolio.

    Exxon Mobile: 2016 $60 LEAPS, cost to purchase $34.31.

    At the time of purchase Exxon was trading at $94.31.

    To calculate the time value add the strike price of $60 and the option cost, $34.31. This sums to $94.31, indicating there is no time value on this option. We are paying purely for the intrinsic value.

    The leverage on this option can be calculated by taking the % increase of both the share price and the option.

    For example, because the option is so deep in the money, a $1 increase in Exxon's price will result in an increase in the intrinsic value of the option.

    If Exxon goes up $1, that's a 1.06% increase.

    The option goes up by $1, which is a 2.91% increase.

    2.91%/1.06%=2.75. This tells us that this option represents a 2.75x leverage on Exxon shares.

    Now, how is this system supposed to work? Well according to, Exxon has a fair value of $109. If we assume that this is the price the stock trades at by the end of 2015, then our profit would be (Price-Strike price)/cost of option.

    ($109-$60)/($34.31)=42.82% profit. This annualizes to 23.79% CAGR.

    This is the profit to be expected if Exxon achieves its fair value, (today) over the next 2 years. However, because the company is actively trying to increase its Fair Value we hope that the stock not only catches up to its Fair Value in 2014 but reaches its Fair Value in 2015.

    From this fast graph we see that analysts are projecting Exxon reaching $116.12 by the end of 2015. If this target price is reached then our profit becomes ($116.12-$60)/$34.31=63.57%. This is equal to 34.27% CAGR.

    So that is the basics of this portfolio. I have found 6 undervalued blue chips that are predicted by analysts to increase greatly over the next 2 years. I have purchased a portfolio of 6 deep in the money LEAPS and will track how this portfolio does relative to the S&P 500.

    A note of caution: options are speculative and this method should not make up more than 10-15% of one's total portfolio. I am running this experiment to see how it will work over the next 20 months. However, the market is now in its 6th year of a bull run and a correction may result in losses to this portfolio.

    After a market correction, especially after a recession, this system could certainly result in exceptional profits and minimize the risks that are currently associated with it. These risk minimizing features are:

    • undervalued blue chips
    • deep in the money LEAPS, with essentially no time value to decay
    • After a recession, blue chips can be expected to grow by 30-50% over a 2 year period. This would optimize profits and minimize risk to the down side.

    Ok, so what does my portfolio look like?

    Company Date S&P 500 start Share Price (start) LEAP LEAP price Time Value (%) leverage Morningstar Fair value Anticipated profit (%) Anticipated CAGR% Fast Graphs 2015 Price Target Anticipated Profit (%) Anticipated CAGR (%)
    XOM 3/23/2013 1866.52 94.31 2016 $60 34.31 0 2.75 109 42.82 23.79 116.12 63.57 34.27
    F 3/23/2013 1866.52 15.47 2016 $10 5.55 0.52 2.79 25 170.27 81.37 28.71 237.11 107.03
    GM 3/23/2013 1866.52 35.01 2016 $20 15.31 0.86 2.29 57 43.63 24.21 94.53 386.81 157.98
    CSCO 3/23/2013 1866.52 21.64 2016 $15 6.95 1.43 3.11 26 58.27 31.64 31.32 134.82 66.72
    CVX 3/23/2013 1866.52 115.63 2016 $90 26.85 1.06 4.31 132 56.42 30.72 169.82 197.28 92.01
    COP 3/23/2013 1866.52 67.48 2016 $57.5 10.85 1.29 6.22 75 61.29 33.14 91.5 213.36 98.17
    AVG         99.82 0.86 3.58   72.12 37.48   205.49 92.7
    • Exxon Mobile (XOM) Jan 2016 $60 call
    • Ford (NYSE:F) Jan 2016 $10 call
    • GM (NYSE:GM) Jan 2016 $20 call
    • Cisco (CSCO) Jan 2016 $15 call
    • Chevron (NYSE:CVX) Jan 2016 $90 call
    • ConocoPhillips (NYSE:COP) Jan 2016 $57.5 call

    For the purposes of the experiment I am assuming a purchase of a single option as listed above. It would require $9,982 to do this plus commission, ($5 for up to 5 contracts at Optionhouse). With commission the total cost of this portfolio is $10,012.

    Note that because the high cost of the XOM, CVX and COP options, 70% of the portfolio is in these 3 companies. Ideally the portfolio would be better balanced. However, with my advised 10% maximum allocation to this system of investing, the above portfolio is designed to represent the smallest amount advisable to invest in a portfolio of total size $66,677-$100,000 and thus the most realistic to interested investors.

    I will be updating this portfolio on a monthly basis and potentially adding more companies should I come across undervalued blue chips that fit the investing criteria outlined above.

    I invite interested investors to follow this experiment along with me and to offer their own potential ideas. Whether it be to improve the system or with potential portfolio candidates.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: XOM, F, GM, CSCO, CVX, COP
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Comments (3)
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  • howrad
    , contributor
    Comments (20) | Send Message
    Camille, thanks for the article. Have you considered selling nearer term OTM calls covered by the ITM LEAPS? I haven't done this but it would seem to be a way to generate income (a synthetic dividend if you will).
    25 Mar 2014, 06:14 AM Reply Like
  • TimeOnTarget
    , contributor
    Comments (3679) | Send Message
    Interesting idea with a good explanation. Thanks.
    25 Mar 2014, 12:21 PM Reply Like
  • Cameron Swinehart
    , contributor
    Comments (301) | Send Message
    Camille, very nice write up. It is a very interesting strategy and I look forward to future articles.
    25 Mar 2014, 11:56 PM Reply Like
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