LEAPS: Options for the Long Term - Part 6
...continued from Part 5
The purchase of LEAPS puts to hedge a stockposition may provide investors protection against declines in stockprices. This strategy is often compared to purchasing insurance onone's home or car, and may give investors the confidence to remain inthe market. The amount of protection provided by the put and the costof the protection, sometimes evaluated as a percentage of the stock'scost, should be considered.
For example, ZYX is trading at 45and a ZYX LEAPS put with a three-year expiration and a strike price of42½ is selling for 3½ or $350 per contract. These puts provideprotection against any price decline below the break-even point, whichfor this strategy is 39 (strike price less the premium). The investor'srisk or maximum loss is limited to the total amount paid for the putoptions or $350 per contract. The following are possible outcomes ofthis strategy at expiration.
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STOCK ABOVE THE BREAK-EVEN POINT
IfZYX is trading at 48 at expiration, the unexercised put would generallyexpire worthless, representing a loss of the option premium or $350 percontract.
STOCK BELOW THE STRIKE PRICE
The put would beprofitable if the stock closed below 39 at expiration. If ZYX istrading at 37½ at expiration, the 42½ put, upon exercise, would have avalue of 5 or $500, representing a profit of 1½ points or $150 percontract. This profit will partially offset the decline in the value ofthe stock.
STOCK BETWEEN THE STRIKE PRICE AND THE BREAK-EVEN POINT
IfZYX is trading at 41½ at expiration, the 42½ put would be valued atapproximately 1. This means that, upon exercise, a portion of theoption premium would be retained and the loss would then be 2½ pointsor $250 per contract. If the contract is not exercised or sold, theinvestor will lose all of the initial investment, or $350 per contract.
...continued in Part 7.
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