Leaps-Perhaps Time to Pull Out Another Tool from Your Arsenal.

Time to Consider LEAPS

Low interest rates and low volatility mean LEAPs MAY be a cheap, non-recourse loan for owning a growing business or a way to lower your over-all exposure without giving up returns.

Rising interest rates and volatility (all else being equal) will raise the price of your leap. If you believe a company will grow its intrinsic value 10% to 15% in the next 18 months to two years then leaps may be an attractive tool. Option traders’ models do not do as well as the cone of uncertainty increases (the time period until expiration is beyond a year).

A refresher on options:Options_Guide but the Bible on options is Options As a Strategic Investment by Lawrence G. McMillan. See Chapter 25, Leaps.

Lecture by a Great Value Investor on using Leaps:  Lecture-8-on-LEAPS         A MUST READ.

Application of Leaps

This blog discusses using Leaps for Cisco during 2011. http://www.valuewalk.com/2011/07/cisco-leaps-opportunity-lifetime/

I am not recommending that you agree, but follow the logic.

If you are new to investing then stay away, but for some, NOW may be a time to use this tool with the right company at the right price.

Good luck and be careful not to over-use options. Options, when you are successful, can become as addictive as crack–who doesn’t like making 10 times your money?

14 responses to “Leaps-Perhaps Time to Pull Out Another Tool from Your Arsenal.

  1. John, Are you any good with Black and scholes?

    I posted something about it here:
    http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/black-scholes-and-long-dated-options/

    And would love to get some feedback. It seems to me the formula is wrong using risk free interest rate as the “drift”, or the constant growth in the stock model, and instead should use cost of equity.

    • The BS model uses the risk free rate is because you can in theory replicate the payoff of options with the underlying stock and risk-free bonds.

      I’ve never used options but it seems like LEAPs may be used in situations where most traders are pricing using a B-S framework but you think the price will either go up a lot of go down a lot. I think a binary situation like this would lead to mispricing if someone is just trading on historic volatility. I glanced at your forum posts and I think your line of thinking was sort of along these lines.

      Of course, I have no experience in this area so would love to hear from anyone that has used LEAPs in the past…

    • No, I have no clue.

      I use LEAPS as a proxy for owning shares in SPECIAL Situations. Say you have a company trading at $19 and you believe the intrinsic value resides $25 to $35 range with activist controlling the company who will sell parts of the company to ay down debt. Or a company that is a franchise and is growing each year so time is more on my side. The market goes off of volatility, interest rates, dividends but becomes more inefficient beyond one or two years.

      I the increase in intrinsic value more than makes up for the declining time value, I will do OK, or re-up if the price goes lower–assuming that the cost of the non-recourse loan (I don’t have to pay for shares) is reasonable. I don’t fiddle with a computer.

  2. Also, I suspect having a catalyst in your thesis that forces the market to re-evaluate the valuation of the company may be a good thing. I’ll try to see if my friend can answer your earlier question tonight when I get home from work.

  3. Arden,

    Not sure what you’re trying to ask here but I’ll assume that your question is “Why is risk free rate the correct rate to use to value options (long term or short term doesn’t matter)?”

    Let’s forget about all the B-S math for second and think of financing cost then it’ll become clearer. If you don’t have any money and want to finance your purchase of stock you’ll pay a certain amount of interest. This interest is what determines the value of a forward or a future or an option. Doesn’t matter whether the forward (or option) is on a commodity, stock or real estate. And this rate has nothing to do with the cost of equity for the company. It shouldn’t.

    The reason this rate will be the risk free rate (or close to it) is that if it’s higher then a bank can create a position that helps it lend at that rate and earn higher interest than risk-free while taking NO risk. Similarly, if it’s lower then the same bank can create a risk less position that can have them borrowing at that rate.

    Your opinion that the stock will go up by a much higher rate than risk-free doesn’t really matter. If ROE is 10% and the company re-invests everything and it has moat etc etc then in your mind that drift is 10%. So you will think that LEAPS are cheap but how is this ANY different than you thinking that the stock itself is cheap? Assuming you can borrow at the risk-free rate you just finance the purchase of your undervalued stock. Pay 2%, earn 10% and not put up much capital. Immense returns!

    LEAPS may be the only way for an individual to get that 2% loan to buy the stock. But that doesn’t mean that people should start pricing leaps in accordance with the ROE or the borrowing/lending rate for individuals.

    Apologize if I answered the wrong question. Happy to elucidate or share my views around leaps and options in general. I’ve traded them personally and institutionally for several years now.

    As for B-S … everything that B-S does can actually be explained in simple intuitive terms without the math. Most books unfortunately fail to do so.

    cheers

  4. Why get involved with leaps when there are specialists pricing them when you can go buy +4 yr warrants (kmi/GM/etc) from “non economic” sellers. Google GM warrants, you’ll see questions on forums from the unsecured claimsholders like “what is a warrant” “my broker called and told me I got these warrants for my GM bonds what should I do?”. Great pond to fish in at the moment.

    John Chew keep up the GREAT work. Everyday I get a boner just thinking about what new content I might find on this wonderful little website.

  5. Comatozz, Great answer! I think to think about it a bit 🙂

  6. Ok, few questions before I can put this behind me 🙂
    1. How exactly can the bank make money without risk if the rate is any different than the risk free rate?
    2. How do I figure out which “loan” I am implicitly taking when buying a leap? (Hope this isn’t too complicated..)

    • No worries. Intuitively (rather than mathematically) …

      1. Let’s say that the one year risk free rate is 2% and that banks can easily lend/borrow at that rate.

      Also, let’s say there’s a stock with options that can ONLY be traded by individuals and not banks. For some reason individuals are pricing these options at a much higher rate (say 10% because they think ROE is the right rate). In this case calls will be very high in price and puts will be very low.

      The reason for this is that as rates will go higher your propensity to finance a stock purchase will be lower compared to your propensity to finance a call purchase. As in, why spend $100 on a stock and pay $10 in interest when you can buy a call for $7 and pay $0.70 in interest. Similarly your propensity to short the stock will be higher than buying the puts. So as rates go higher (all else equal) you want to substitute our stock with calls and your puts with shorts. Hence calls become richer and puts dearer.

      Ok so now let’s say this market suddenly opens up to the bank. This bank can now go out and start selling the (high priced) calls and buy the (low priced) puts of the same strike. This is effectively a short stock position at a very high rate. At the same time the bank can buy the stock financed at a very low rate (2%) and is now in a risk less position. This position (long call, short put, short stock) will generate very high returns for the bank and the banks will keep doing this trade until the calls and puts are priced to the correct rate. That correct rate is nothing but the risk free rate.

      Greenblatt also talks about this “forward conversion” trade in his lecture.

      2. It’s not too complicated. Intuitively, if a 1 yr ATM call on a $100 stock is trading at $5 then you’re essentially getting a loan if you buy the call instead on the stock (in other words you’re saving $95 that you can put in a bank and earn interest on). You are also getting protection i.e. stock goes to $50 you lose only your $5 if you buy the call.

      But if you own the stock already how can you create such a protection without replacing your stock with a call? Well, by simply buying the 100 strike put!

      So if 100 strike put is let’s say $3 then you can create this protection by spending that extra $3. Now you have the same risk as if you replaced your stock with a call. So your call price should comprise of the value of financing + value of protection. Value of protection we know is $3 (put) so the value of financing = 5-3 = $2. This is the imputed interest on your $100 loan.

      Formulaically (and approximately), to calculate the interest cost on your loan first calculate the difference between the call and the put (A). Then calculate the difference between the stock and the strike (B). The difference between (A) and (B) is the interest you’re paying on the strike.

      So if for a $100 stock, the 90 strike call = $14 and 90 strike put = $2. Then A= $12 and B = 10. So interest cost on $90 = $2 hence 2.2% interest rate.

      This is all approximate but close enough. Hope this helps

      cheers

  7. Like Arden above, I am struggling to calculate the “implicit interest rate” when looking at options. I’ve read Greenblatt’s explanation many times and think I am missing something. Can someone who’s mastered this calculation lay it out in a formula? Is this available as an output on bloomberg? Thanks in advance

  8. Approximate formula and explanation above. A more robust formula comes from put-call parity: call px -put px = stock px – PV(strike + dividends). Solve for interest rate. Make sure call and put are same strike and maturity. You’ll have to assume the dividend stream.

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