Hello, sports fans. I got a few interesting follow-up questions on my recent LEAPS posts (you can catch up on those here and here). Today's post goes out to all you margin traders, who might be asking yourselves: how does buying in-the-money LEAPS call options compare with going long an equivalent amount of stock on margin? The short answer is: very well. After reading this you might not ever trade on Margin again. Let's consider a theoretical example: you want to control 200 shares of IBM stock, but you only have the bucks currently for either 100 shares of stock OR 2 LEAPS representing 200 shares of IBM stock. Which should you go for, and what factors will influence your choice? The following example lays out the comparison points. The factors we need look at are the amount time premium left in the option and compare that to the amount of interest paid to carry the stock position on margin. The time value in the option contract will wither away as expiration approaches. In the world of option trading this time value equates to the carry cost of the over the life of the option. As you'll see, assuming you pick a way in-the-money LEAPS option which is made up of mostly intrinsic value and has a delta of 95 or higher, the time premium in the option will usually equal or many times be less then the interest costs of holding the position on margin over the same time period.
Prices and rates as of 4/01/2008
Buy 200 shares of IBM @ 117.90 = $23,580
Pay $11,790 and margin $11,790
Margin interest rate = 5.00 %
VS.
Buy 2 IBM January 2010 60 Calls @ 59 = $11,800
Pay in full $11,800
Days to Expiration 654
Intrinsic Value for each contract = 57.90
Time Value for each contract= 1.20
Delta for each contract= .94
So let's compare the carry cost of each position, when dealing with leveraged trades carry cost is what it is all about. The LEAPS option has 654 days until expiration, to make the math simple let's assume we stay in both the stock and option trade for the entire period. On the purchase of stock the margined dollar amount is $11,790 and the equates to a interest rate cost per year of $589.50 (.05 x 11,790) since the period is longer then a year the (654 days). Total interest for the time period would be (654/365) x $589.50 = $1,056.25. Don't forget that IBM does pay a dividend, since we are the owner of stock we would be entitled to that dividend. Currently the dividend is .40 cents paid once a quarter. Assuming 7 dividends paid over the period the credit back would be $560.00 (.40 dividend x 200 Shares x 7 total paid). This makes the total carry cost for the margined position $1,056.25 minus $560.00 or $496.25.
Whew, the carry cost of the LEAPS options is simple. It is just the time value of the option times the number of contracts. The carry cost is $240 ($1.20 x 2 x 100). The owner of the option is not entitled to any dividends paid, but the actual call price does reflect if underlying stock does or does not pay a dividend. FYI... When an underlying stock declares a new dividend it will usually cause the market place to adjust the price all the options on the underlying. The normal is for a decrease in call premiums and an increase in the put premiums.
Things worth noting:
So are these two approaches totally equivalent? Not entirely. The carry cost for the LEAPS position ($240) in this case is less then the margined stock trade ($496.25). The delta on the LEAPS is very close to one (.94) so if the stock does increase in price the LEAPS position should approximate, but not equal the move. If you buy LEAPS, you'll never have to worry about getting a margin call, when buying options the risk is limited to the total dollar amount paid. But you will have to keep your eye on the LEAPS expiration date, however distant it may seem. Buying stock on margin offers this tradeoff in reverse: you usually can stay on margin for as long as you like, without the position expiring, but you may have to pony up more cash if the stock declines and you get a margin call along the way.
Regards,
Brian (OG)
[image: jump-rope by isado on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
