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Author: TMFHamp Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1326  
Subject: LEAPS as Stock Substitute Date: 3/19/2007 11:48 AM
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Using LEAP (i.e., long-term) call options as a stock substitute is a well-established investment strategy. The benefit is that you get almost all of the stock's appreciation potential at a much lower out-of-pocket expense. For example, buying 100 shares of GRMN at the current price of $53.70 would cost $5,370. In contrast, you could buy a January 2009 $40 call for $18.45 per share or $1,845 per contract. This call has a delta of 0.85, meaning that its value increases by 85 cents for every $1 the stock price increases. So, for almost the same upside exposure, you save $3,525 in out-of-pocket cost, and this cost savings can stay in your money market account earning interest.

A few negatives do exist. First, the option is leveraged so if the stock declines the option will lose a larger percentage of its value. If Garmin falls to $40, the stock will lose 26% of its value whereas the call option will fall to $8.05, a loss of 56%. However, this percentage loss is off of a much smaller dollar investment, so the options position actually loses less money in dollar terms. After all, wealth is determined by dollar amounts, not percentages. A 26% loss on a $5,370 investment is a dollar loss of $1,396, whereas a 56% loss on an $1,845 investment is a dollar loss of only $1,033. And don't forget that if the stock price rises the option benefits from positive leverage.

Second, call options do not pay dividends. However, call option prices are adjusted downward by the Black-Scholes valuation model for the lack of dividends. So, in a theoretical kind of way, you aren't penalized. But you should not expect to receive dividend checks in the mail

Third, options suffer from time decay. If Garmin's stock price stays stagnant at $53.70 until January 2009 expiration, the $40 call would be worth $13.70 per share, which would amount to a loss of $4.75 per share from the current value of $18.45. In contrast, the owner of Garmin stock would lose nothing.

In conclusion, buying LEAP calls as a stock substitute has pros (lower out-of-pocket expense and positive leverage) and cons (negative leverage, no dividends, and time decay).

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