Video #3 in our 4-part series, featuring Bryan Perry, Investing in LEAPS (Long-term Options) for Short-term Income.
VIDEO #3 TRANSCRIPT:
Roger: Hi, this is Roger Michalski, publisher of Eagle Financial Publications. Welcome to video three of our series. We’ve been talking with Bryan Perry about LEAPS, which are long-term options, and, in the last video, we talked about a covered call strategy on these LEAPS. So, we have a nice long-term strategy and a short-term strategy where you can get instant income from these big name stocks.
So, Bryan, can you walk us through an example of exactly how a trade would be executed?
Bryan: Sure, it’s hard to be involved in the market on any given day without hearing about or seeing Facebook across the table. On Bloomberg or CNBC, it gets a lot of press. It’s in a lot of hedge funds, it’s in a lot of big-time, growth management funds and as companies continue to power up their earnings and do very well technically and fundamentally.
So, that’s a typical example, Roger, of a stock that I want to be building a LEAP portfolio around, something where it’s trading at $120 a share. It moves around, it’s got some volatility to it so you get some nice wide option premiums to it. There’s a lot of short-term speculative money in it that we want to sell that greed back to them using the short-term covered calls strategy on top of a long-term LEAP.
We want to put these trades together where we do have a long-term time horizon for the stock, but we want to sell short-term greed back to the market, and Facebook is a great example of how to do that. It gives people a chance to put together a kind of a trade where, typically, these trades are designed and financially engineered to return anywhere between 40% and 80%. That’s how you make money intelligently in the option market, by putting together a Bull Call Spread.
So, we have a PowerPoint presentation that goes through that in chapter and verse and we would like to show it to you.
Roger: Alright, let’s take a look at that right now.
Bryan: Okay, Bryan Perry here. We’re going to walk through a sample trade here for using the stock Facebook, (FB) – very actively traded name, institutional favorite, super growth stock right now, and a powerful earning story behind it, great fundamentals, great technicals, trades tremendous amount of average daily volume and very liquid option chains with very tight spreads. It has all the things we find that fit the profile of a really good Bull Call Spread trade.
A lot of people want to own Facebook stock because you can collect big cash payments from the sale of call options against the stock. The problem: like any of these big name stocks, the stock costs over $100 a share, so you’d have to put up more than $10,000 just to buy 100 shares of stock in which to sell just a single call option contract.
Looking at the stat. page for Facebook, you can see the stock is trading up at near its all-time high. It has traded as high as 121, so the stock is trading within 5% of its all-time high in a very tough market, almost a negative take for the year. At the same time, you have one year estimated targets of 142 on average by the analysts’ communities, so there is still a tremendous amount of upside for the company.
The solution for us as income investors is to buy the Facebook January 2017 90 LEAP Call at $31 per contract, and you have to pay only $3,100 out of cash to control that same amount of stock. $31 a contract translates to $3,100 in cash out of pocket.
Then you immediately sell the Facebook July 2016 120 Call Option, using the LEAP contract as security at $4.20 per contract. So you immediately collect $420 in call option premium in your brokerage account, cash in your account that you can spend immediately if you want.
Now, two things can happen:
Either Facebook stock will hit the strike price of the call option you sell…in this example, $120 a share, by the expiration date…or it doesn’t. If it doesn’t hit $120 per share by the time the call option expires on July 15, then nothing happens. You just keep the cash and you still keep your LEAP as well.
To calculate your return on this trade, you divide the $4.20 call option premium by $31 cost of the LEAP call, and you come up with 13.5%. So, you make 13.5% on your money in just 60 to 90 days. Do that over and over again, four times a year, and you have an annual return greater than 50%.
Now, what happens if Facebook shares DO hit the strike price and close above $120 a share by the expiration date of July 15? In that case, you also make money, just a little less. If the stock is called away on July 15, the $90 LEAP call is worth $30 in terms of its intrinsic value. You add the $4.20 call premium, you come up with a total gain of $34.20 per contract. Minus the $31 cost of the LEAP, and you end up with a net sum of $3.20 net profit. To calculate your return, you divide $3.20 net profit per share by $31 (the cost of the LEAP contract per share) for the Facebook LEAP, which works out to a 10.3% profit for a roughly two-month time frame.
So it’s pretty much a win-win. You keep the option premium either way…and the only unknown factor is whether the call option you sell is exercised or not.
And the great thing is this:
This strategy allows investors who don’t want to invest $10,000 or more in big name stocks to still collect the juicy call premiums that are available for these “marquee” names. You end up collecting three to four times more money than you would normally be able to by selling covered calls while owning less expensive stocks.
This is the perfect strategy for investors who want instant income but don’t want to tie up too much of their capital in famous stocks like Facebook, Amazon and Google.
That’s the beauty of this Bull Call Spread strategy. You get to play with the big boys, and collect fat option payments without having to put up so much cash.
Roger: And welcome back. Wasn’t that amazing and so easy? But of course there is always risk in every kind of trading. So, Bryan, walk us through the risks in this strategy.
Bryan: Sure, the number one risk to any of these strategies is to be in the wrong stocks. Therefore, it’s important that we design a service that’s around, what we call, institutional darlings. McDonald’s has a bad headline, and it dips 2, 3, 4 points, the short-term money is worried about it, the long-term money is in there buying it because they live for that kind of opportunity to buy these big name stocks for the next 20 years on dibs.
We want to be in that position where we’re in those types of names where there’s always big long-term pools of money that love to buy these stocks on pullbacks. In doing so, when we have a long-term LEAP, we’ve bought time. Time is on our side. Conversely, we’ve sold the short-term covered call against that LEAP. Therefore, if we have a $30 LEAP, and we’ve sold a $3 covered call against it, then we have really lowered our cost basis to $27, Roger.
So, we’ve already drawn a line in the sand as to where we think we have identified our downside risk to where we actually start losing money on the trade. If we are at that point in the stock where we were back down to $27, then we have to ask ourselves: Are we fundamentally staying in the trade? Technically, is it still together? And that’s my job. It’s to make sure that every trade is managed properly, and that the risk is managed properly too. Managing risk is just as important as managing profits.
Roger: Yes, so we have the long-term upside, but we’re cushioning that in a couple of different ways. One, is the $100, $400, $700 stocks – we’re buying at a fraction of the cost, so there’s less risk there.
We’re doing a covered call strategy; we’re getting instant income into our portfolios and brokerage accounts, and we’re getting that right away so that’s reducing the risk.
And then, we have the long-term on our side, so lots of different ways to manage risk.
My next question for you, and we’ll get into this in the next video, is how we can use this in retirement accounts. And also in the next video, we have a big announcement for everybody, so stay tuned for that.