Option Basics: LEAPS As A Stock Substitute (4:22)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 4, No. 12 on June 21, 1995.

With the market being so high, many individual investors and institutional money managers as well are wondering what to do with these profits. Completely exiting the market is not a viable alternative for many, and is prohibited by charter for some institutions. However, there is a way in which one can reduce his downside exposure while still retaining upside profit potential — he can sell his stock and replace it with LEAPS call options.

This is not a new idea; it has always been available as a strategy using short-term options. However, its attractiveness seems to have increased with the introduction of LEAPS since one doesn't have to keep "rolling" the options over so often.

Simplistically, the strategy involves this line of thinking: if a stock owner sells his stock, he could reinvest a small portion of the proceeds in an in-the-money call option -- which would provide continued upside profit potential if the stock rises in price -- and invest the rest in a bank to earn interest. The interest earned would act as a substitute for the dividend, if any, to which he no longer is entitled. Moreover, he has less downside risk: if the stock should fall dramatically, his loss is limited to the initial cost of the call.

The costs to the stock owner who decides to switch into call options as a substitute are commissions, the time value premium of the call, and the loss of dividends. The benefits are the interest that can be earned from freeing up a substantial portion of his funds, plus the fact that there is less downside risk in owning the call than in owning the stock. There generally is a net cost of switching — that is, the interest earned won't completely offset the loss of the dividend, the time premium, and the commissions.

The stock owner must decide if it is worth that cost in order to have his downside risk limited over the life of the LEAPS options. If the investor decides to make the substitution from stock to calls, he should invest the proceeds from the sale in a CD or T-Bill whose life approximately matches that of the LEAPS option.

Caveats

The cost to switch may seem like a reasonably small price to pay to remove a lot of downside risk. However, one detriment that might exist is that the underlying common might declare an increased dividend or, even worse, a special cash dividend. The LEAPS call owner would not be entitled to that dividend increase -- in whatever form -- while, obviously, the common stock owner would be. If the company declared a stock dividend, it would have no effect on this strategy since the call owner is entitled to a stock dividend.

There may be other mitigating circumstances, involving tax considerations. If the stock is currently a profitable investment, the sale would generate a capital gain, and taxes might be owed. If the stock is currently being held at a loss, the purchase of the call would constitute a wash sale and the loss could not be taken at the current time.

Protecting Existing Stock Holdings With LEAPS Puts

What was accomplished in the substitution strategy discussed above? The stock owner paid some cost in order to limit the risk of his stock ownership to a fixed price. What if he had just bought a LEAPS put instead? Forgetting the price of the put for a moment, concentrate on what the strategy would accomplish. He would be protected from a large loss on the downside since he owns the put, and he could participate in upside appreciation since he still owns the stock. Isn't this what the substitution strategy was trying to accomplish? Yes, it is. Moreover, when buying the put, only one commission is paid -- that being on a fairly cheap out-of-the-money LEAPS put -- and there is no risk of losing out on dividend increases or special dividends.

The comparison between substituting a call or buying a put is a relatively simple one. Merely compare the cost of switching with the cost of the put. If arbitraguers are doing their job, the put will probably be the better way to go. Moreover, capital gains don't have to be realized with this method. The purchase of a put may suspend his holding period for tax purposes (if he is not already a long-term holder), but the LEAPS call strategy had its own tax complications as well.

Thus, any stock holder who is thinking of protecting his position can do it in one of two ways: 1) sell the stock and substitute an in-the-money call, or 2) continue to hold the stock and buy an out-of-the-money put to protect it. LEAPS calls and puts are amenable to this strategy.

This article was originally published in The Option Strategist Newsletter Volume 4, No. 12 on June 21, 1995.