Updated: Feb 16
Buying in-the-money calls in lieu of buying shares is a very effective strategy for dynamic investors looking for an optimal risk/reward. By buying long-term in-the-money calls, called LEAPs, we are leveraging an underlying security, be it a stock or ETF. As you've just read, we're dealing with 'leverage' meaning our primary goal is to amplify our returns... This article will guide you through a real-life example and position we still have on in our portfolio: LEAPs on Microsoft.
What underlyings should we use?
It's no secret that I love high-quality low-volatility stocks with predictable cash flows, an excellent management team and excellent momentum. When the big boys (institutional investors such as pension funds, hedge funds) favor stocks that are less volatile than the broader market, I'm in. So, we're not targeting short-term speculative trades!
If you are a long-term buy and hold investor looking to allocate your cash to a mix of both ordinary shares and LEAPs, you'd better focus on low-volatility stocks because they suffer less during drawdowns, frequently set new all-time highs and have cheaper options associated with them. In this article I'd like to focus on Microsoft. Below, I've inserted the monthly chart for Microsoft with the 12-month Moving Average because the long-term picture is what I'm interested in. Short-term fluctuations are noise for those buying in-the-money LEAPs.
We see that the drawdowns are being stopped at the moving average line, indicating Microsoft's uptrend is as strong as it can be. We don't see huge swings in its share price and we want to capitalize on its excellent fundamentals: operating margin of 37% and a 3% free cash flow yield growing by 12% - 15% per year.
What LEAP to select?
The next question that comes up is what option do we buy? We currently have the $120 calls expiring in January 2022. Let's have a look at the current price of these options and feed the information into my calculator.
Let's assume for a moment that Microsoft shares will produce an annualized return of 17.37% over the coming 2 years (which corresponds to a price of $250 by the end of January 2022). What does that mean for anyone buying the $120 calls today?
Let's have a look at the options chain and compare different strikes: $100, $120, $145 and take the mid-price of the spread. Because of the SEC fill-rule, you can always negotiate a better price than indicated by the bid or ask price. Just adjust your limit price little by little before your order ultimately gets filled.
The $120 Call: Our Reference
Let's start off by looking at the $120 call, for which we pay around $540 in time value, while the remaining part is intrinsic value. If we were to buy this call option, we are finally going to lose the time value component. That means in order for us to benefit from a LEAP, the price has to go up by more than the time value we paid, in other words: current share price + time value = breakeven. The more time value you pay, the higher your breakeven but the higher your leverage effect (see later).
As a result, we'd better immediately factor in this consequence. Over the next 715 days, Microsoft is expected to pay cash dividends of $360 per 100 shares. We as call buyers won't get these distributions!
Now, what happens if Microsoft stays flat during the next 715 days? In that case, we lose the time value component of $540 or 0.36% if you have a hypothetical $150,000 in your portfolio.
What if the stock price declines? We can then determine our loss by computing the difference between the intrinsic value left in the option and the premium we paid. Our maximum loss is defined.
If shares are below the strike price near expiration Friday, you'll lose the entire premium you paid, or 4.71% on your portfolio value in this hypothetical.
If Microsoft goes up to $250 by the end of the contract period, or whatever price above your breakeven, you can easily define your final profit: ((current price - strike price) - premium paid) * 100 * number of contracts. In this case: $250 - $120 = $130 - $70.7 = $59.3 * 100 * 1 = $5,930. This represents an annualized return of 36.47% over the next 715 days.
But what if you buy shares of Microsoft worth the premium of the $120 call? In that case, you're just a shareholder with no expiration date or leverage effect. We can buy 38 shares of Microsoft if we want to spend the same 7,070 dollars.
Based on the same portfolio value, you can only count the dividend as profit if nothing happens.
Your annualized return is much lower as is the dollar profit.
There's no expiration risk.
You don't pay time value.
If Microsoft drops below $120, you lose 1.65% of your portfolio value.
When you're buying 100 shares, that's equivalent of 1 options contract. The difference relates to the time value component, but LEAPs require less capital than buying the shares right away. Below you have a comparison table:
If by the end of the contract period Microsoft drops below the strike price of $120, we lose the entire premium we've paid for the call. That results in a yearly write-off of 2.41% over the next 715 days.
When we're buying LEAPs, we have to be able to evaluate what can happen to our portfolio value. If a strong long-term case can be made for Microsoft, then the LEAPs serve as an excellent substitute for common stock. We only use LEAPs if we're bullish on the stock and are willing to pay a certain amount of time value.
The $100 Call: More Defensive
Now, let's figure out what the difference is between selecting the $100 and $120 call. By buying this call option we must recognize the following consequences:
The premium we have to pay is larger because there's more intrinsic value (pretty obvious); so we can lose more... But the chances of success are higher (the stock has to depreciate a lot before we lose everything).
We pay less time value ($280), so if nothing happens to the underlying, we won't lose as much as in the case of the $120 call --> 0.19% loss on portfolio value versus 0.36%. Our breakeven is lower than for the $120 call: current price + time value per share paid = $188.10.
In this case, our annualized return is lower because we had to come up with more cash to buy the LEAP.
Higher spread between the bid and the ask!
For ordinary shareholders, nothing changes in terms of the annualized return, however, the equivalent of the call premium now represents 47 shares in Microsoft.
If by the end of the contract period Microsoft drops below the strike price of $100, we lose the entire premium we've paid for the call. That results in a yearly write-off of 3.00% over the next 715 days. In terms of time value, we lose 0.10% every year.
Compared to the $120 call, our leverage to the upside is lower because of the higher investment.
The $145 Calls: Less Capital Required; More Time Value Paid
Let's dig deeper into the difference between selecting the $120 and $145 call. By buying this call option we must recognize the following consequences:
Less capital required
Time Value component relative to the entire premium paid increases; so in case nothing happens, we'll lose a lot more. Consequently, our breakeven is higher. We lose more if nothing happens, but lose a lot less if we get a steep drawdown. 0.71% of our portfolio value can be lost if Microsoft shares are here to stay.
Higher leverage effect if we get a substantial up move
Our annualized return is noticeably higher if the price supersedes the breakeven point
For ordinary shareholders, nothing changes in terms of the annualized return, however, the equivalent of the call premium now represents 27 shares in Microsoft.
If by the end of the contract period Microsoft drops below the strike price of $145, we lose the entire premium we've paid for the call. That results in a yearly write-off of 1.74% over the next 715 days. In terms of time value, we lose 0.36% every year.
Compared to the $120 call, our leverage to the upside is higher because of the lower investment.
The more time value you pay (relative to the entire premium), the higher the strike price, the more money you can eventually lose if nothing happens and the lower your probability of profit (higher breakeven point)
Always sell your LEAPs before expiration, otherwise they'll expire worthless! Option buyers have the right, not the obligation to buy 100 shares of the underlying security
You can sell your options at any time during the contract period
Actual breakeven = current share price + time value paid
Maximum loss is defined, maximum return is unlimited
Your profit: difference between share price near expiration and your breakeven level
You don't get the dividends!
The lower the strike price, the more you invest, the lower your leverage effect but the higher your probability of profit (because of the lower breakeven level that matches the current price of the stock)
LEAPs benefit from rising volatility, which can help offset temporary losses.
Selling Short Calls Against LEAPs
Instead of just buying LEAPs and hoping for a happy outcome, you can steadily reduce your investment by selling calls against your covered LEAP positions. For our portfolio, I figured out that it would take about 5 years to regain our investment in LEAPs while allowing for significant share appreciation. Just like with ordinary covered call writing, we have to determine what our goal is. In this case, we want to generate additional income on the LEAPs we own.
If you bought the $120 calls, you are then free to sell an equal amount of short-term calls against that position. Your maximum return when ignoring the time value component of the LEAP? ((Short call strike price - strike price of the LEAP) * 100 * number of contracts) - premium paid. The more upside potential you want, the lower the short-term call premium will be.
For the $200 short call, you receive $159 per contract. We can use that cash to pay down our investment and thus lower our breakeven. If you bought the $120 LEAP, you paid $7,070. Your maximum return if shares of Microsoft hit $200 by March 20, 2020 stands at (($200-$120) * 100 * 1) - $7,070 = $930 + $159 = $1,089.
Note that this profit number doesn't take into account the time value component that's still attached to the $120 LEAP, so the actual profit will be higher as the $120 call will still have time value (which I ignored in this example, for the sake of simplicity). Including the time value component, the profit will be around $1,500. If Microsoft rises above the short call strike price, you can always roll out to the next expiration cycle.