The Weekly Options Strategist - 07/22/08

LEAPS May Be the Right Option Now

The United States economy is under severe pressure on multiple fronts, and there
probably are no quick or easy cures for what ails it. Equities, meantime, have fallen into
bear territory, dragged lower by a troubled financial sector. So, what’s an investor to do?
Valuations have certainly improved, at least based on historical data. The median
price/earnings ratio of Value Line stocks, for example, as well as for stocks in the Dow
Jones Industrial Average are at levels near the last (October, 2002) market bottom.
Dividend yields, too, are far more characteristic of market bottoms than of tops.
Unfortunately, however, the turmoil enveloping various sectors of the U.S. economy very
much calls into question the near- and intermediate-term prospects for earnings,
dividends, and other financial metrics that are generally utilized to value common stocks.
All that said, we would note both that markets typically turn up when the news is dire and
pessimism is rampant and that burying one’s head in the sand is clearly not a wise course
of action for investors. With this in mind, in this week’s report, we discuss the various
ways that LEAPS (acronym for Long-Term Equity AnticiPation Securities) can be
utilized.

An Economy Under Stress

The most current data show that the U.S. economy expanded 1.0% in the first quarter of
2008. Moreover, the Federal Reserve’s aggressive easing of interest rates over the past
year and the government’s rebate checks in recent months likely kept GDP (gross
domestic product) growing at a modest in the three-month period that ended on June 30th.
Indeed, contrary to wide expectations, the country may well avoid a recession this year,
at least by the official definition of recessions—two successive quarters of economic
contraction. Most Americans, however, probably feel like the nation is in a recession.
Housing, which represents Americans’ largest investment, continues to weaken, and there
are no signs of a bottom. Furthermore, payrolls are declining with the unemployment rate
a full percentage point above where it was a year ago, at 5.5%. The inflationary pressures
from continually surging oil, food, and commodity prices, meantime, inhibit the Fed’s
ability to employ monetary policy to stimulate macro business activity; the price of oil
recently approached the $150 a barrel level before retreating, and a gallon of gasoline
exceeds $4. Disconcertingly, too, the financial sector’s problems, which are directly
connected to the housing sector’s challenges, seem to deteriorate daily.

A Growling Bear
As of the market’s close on July 15, 2008, the Dow Jones Industrial Average and the
Standard & Poor’s 500 Index were off 23.2% and 22.9% from their respective peaks,
achieved last October 11th, with year-to-date losses of 17.4% and 17.3%. The technology-
laden NASDAQ had fallen 22.6% since peaking on October 31st, and is down 16.5%

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since the beginning of 2008. Few industry sectors have been spared, and the pain is
global, with most major equity markets around the world sustaining double-digit
percentage losses year to date. Homebuilding, banks, thrifts, and securities brokerage
stocks have been particularly hard hit, with many individual components posting losses
that well exceed 50%. In the last bear market, the DJIA fell 39.7% in a slide that
extended from January, 2000 to October, 2002. The S&P 500 plunged 50.5% during the
same period, while NASDAQ surrendered a whopping 78.4% of its value. In the
previous, brief bear market of 1987, which culminated with the October 19th crash, the
DJIA, S&P 500, and NASDAQ slumped 41.2%, 35.9%, and 36.8%, respectively.

What are LEAPS?

LEAPS, or longer-term equity anticipation securities, are for all intents and purposes the
same as standard call and put options. The only difference is their longer maturities, with
expirations of between nine months and 2-1/2 years. LEAPS are available on more than
1,000 stocks and Exchange Traded Funds (ETFs), most of which are ranked by Value
Line. The average LEAPS call costs 22% of the underlying stock and has about 3.5 to 1
leverage, meaning that for every 1% move in the stock, the LEAPS will probably move
about 3.5%.

The longest-term LEAPS currently available expire on February 19, 2010, the regular
February expiration date for that year. When the maturity of the LEAPS gets down to
around nine months, the LEAPS become regularly listed options and the options
exchanges assign them standard option tickers. Concurrently, the exchanges list new
LEAPS that expire one year further out.

LEAPS have a number of features that make them attractive to options buyers. Key
among them is the fact that even though they cost more, in terms of time premium, than
shorter-term options, they have a relatively low rate of time decay or “theta”. In other
words, they tend to lose their value at a much slower rate. For example, if the price of a
stock were to stay unchanged for one month, a three-month call would lose about 20% of
its value. By comparison, with all things being equal, a two-year leap would probably
lose only about 2.5% of its value in that month.

Strategic Possibilities
As with standard options, LEAPS can be used in myriad ways. Investors anticipating a
rebound in the stock market, for example, can buy a LEAPS call as a substitute for the
underlying stock, especially if the underlying stock is trading at a nominally high price.
Those looking for further declines can buy LEAPS puts, either to profit from additional
weakness or to protect stocks that are already in the portfolio. The LEAPS’ long
expiration gives the holder more time for his or her objective for the stock (market) to be
achieved. Moreover, investors who believe that the prevailing mood in the market have
inflated option premiums can sell “naked” LEAPS calls and puts or engage in covered
call writing. Spreading is also possible, whereby in-the-money or at-the money LEAPS
are purchased and out-of-the-money, or same strike, but shorter duration, options are
sold.

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A Strategy for the Times
As noted previously, LEAPS are more expensive than standard options. It’s also
important to note that they tend to have a very high exposure to changes in implied
volatility; this is especially important to know in a high volatility environment. This
means that if you bought an out-of-the-money LEAPS and its implied volatility fell by
25%, then the price of the option would fall by almost the same magnitude, even with
little change in the underlying stock. Given these features, the prevailing uncertainties in
the economy, along with our expectation that the stock markets will “eventually”
rebound, we think deep-in-the-money LEAPS make sense for a lot of portfolios.

The deep-in-the-money LEAPS are attractive for the following reasons: 1) Their
extended maturities give the holder time for the various problems in the economy to be
worked out and for the stock (market) to rebound. 2) The time premium on these options
can actually be less than the carrying cost of the underlying stock, depending on how
deep-in-the-money. For example, on July 15, 2008, the asking price of the Medtronics
January, 2010 $30 call was $23.70, with the stock trading at $52.51. The time premium
on one contract would be $119 ($30+$23.70-$52.41x100). The cost differential between
owning the stock and the LEAPS is $2,881 ($52.51-$23.70x100), for 100 shares.
Assuming an interest rate of 6% per annum, owning the stock to the option’s expiration
date would cost an additional $259, which is $140 more than the time premium. 3) The
holder of the LEAPS has less downside exposure, with his or her financial risk limited to
$2,370, whereas the stockholder could lose $5,251. All in all, deep-in-the-money LEAPS
offer the advantages of a smaller cash commitment, limited downside risk, and essentially
full participation in the upside. Thus, investors could use LEAPS to take new positions in
beaten down stocks that look good for the long haul and/or replace (as proxies) existing
stock positions in which they want to maintain a presence.

Tips on Trading LEAPS

Long-term anticipation securities tend to have much wider bid and ask spreads than do
standard, short-term options on the same underlying stock. The bid on the Medtronic
option discussed above was $22.40, which is $1.30 below the asking price. So, we urge
investors to at least attempt using “limit” orders when opening and closing positions in
LEAPS. When buying, this means placing a limit price below the ask price. Conversely,
when selling, it means placing the limit above the bid price. That said, we wouldn’t risk
losing an attractive long-term opportunity by trying to save a small sum, especially on
relatively illiquid LEAPS.

Prepared by George Rho

Senior Options Strategist
Vloptions@valueline.com