Nokia's (NOK, Financial) recent 15%-plus drop over the past two days gives us a perfect opportunity to analyze my methodology and logic for purchasing LEAPs in a real-life example.
Here are the facts
Nokia's current price: 6.82
Jan. 2013 5.00 Call Last Price: 2.46
Jan. 2013 7.50 Call Last Price: 1.18
Jan. 2013 10.00 Call Last Price: 0.55
Dividend: Approximately $0.50/share/year
Here are my assumptions:
I have $682 to invest. Trade costs will be ignored.
My fair value estimate for Nokia is $12.50.
My different alternatives, then, are to:
1. Buy 100 shares of the stock outright.
2. Buy a single option on one of the LEAPs and reinvest the cash in a two-year Treasury. The current yield on Treasury is 0.44%, which is is a negligible amount.
(I did not mention a possible third option, which would be to buy multiple LEAPs. In rare circumstances, with strong industry knowledge and high certainty, it may be appropriate to do so.)
So the three ways I tend to look at LEAPs are:
I. Determine the price to fair value of the LEAP on expiration, assuming it will reach my fair value estimate.
II. The account value on expiration assuming either bankruptcy or the stock reaching fair value.
III. The premium I am paying over current price.
I.Price/Fair Value
So I'll make this one simple. Relatively, which of the below, A-D, has the greatest margin of safety? For this, we just need to calculate the price to fair value for each one. I'll assume the fair value of the options as what they would be worth the day of expiration.
A)Nokia: 6.82/12.50= 0.55
B)Jan. 2013 5.00 Call: 2.46/(12.5-5)= 0.328
C)Jan. 2013 7.50 Call: 1.18/(12.5-7.5)= 0.24
D)Jan. 2013 10.00 Call: 0.57/(12.5-10)= 0.23
Right away we can dismiss the D) Jan. 2013 10.00 call. It only provides a slightly improved price/fair value over the Jan. 2013 7.50 call, with a greater likelihood of finishing out of the money.
Therefore, the option with the greatest price/fair value is C.
II. Model Testing with Extremes
As Warren Buffett has said, to evaluate a model, take it to its extremes. So lets evaluate the three remaining opportunities in the following scenarios:
1. Bankruptcy on the day of expiration.
A)Account value=Dividend received ($0.50/share*100 shares*2 years)=$100
B)Account value=Initial principal minus amount invested=$682-246=$436
C)Account value=Initial principal minus amount invested=$682-118=$564
2. Fair value on the day of expiration.
A)Account value=(($0.50/share/year*2 years)+(Fair value))*shares=$1350
B)Account value=(12.5-5)*100+$436=$1186
C)Account value=(12.5-7.5)*100+$564=$1064
3. Overall gain/loss for the two scenarios.
A)97: -85%= 1.1:1
B)74%: -36%= 2.1:1
c)58%: -17%= 3.4/1
C, then is the best choice for our second thought exercise.
III. The cost to borrow.
Premium paid= Strike+ cost of option+likely dividends-current price
A) No premium. Obviously, I have less flexibility as all my funds are tied up.
B) 5.00+2.46+1.00-6.82= 1.64. With 564 days left on the option, that's $1.00 per year.
C) 7.50+1.18+1.00-6.82= 2.76. With 564 days left on the option, that's $1.75 per year.
In this scenario, choice C is much more expensive than choice B.
Discussion:
At this point, the choice has come down to either option B or option C. Option B is more likely to finish in the money, and its risk to reward profile is comparable (although not as good) as option C. Although I would be risking an additional $121 for option B, I would still end up with the majority of my initial portfolio value under a severe deterioration in the company.
LEAPs are best for stocks that are either going to do much worse, or recover. This is why we try to buy LEAPs on underpriced stocks, which we expect will recover.
I'll finish this series with a quote in which Whitney Tilson discusses LEAPs:
"Whitney Tilson: We tend to buy LEAPS on very stable businesses where we think the underlying intrinsic value is growing around 10% annually, the multiple on the stock is likely to expand rather than contract and the options are cheap. Options on low-volatility stocks like WMT, MCD, BRK, MSFT and BUD are cheap and we own LEAPS on all of them."
Disclosure: I am long Nokia Jan. 2013 $5.00 LEAPS.
If you enjoyed these posts pleaseclick follow at the top left, or rate me below.
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Here are the facts
Nokia's current price: 6.82
Jan. 2013 5.00 Call Last Price: 2.46
Jan. 2013 7.50 Call Last Price: 1.18
Jan. 2013 10.00 Call Last Price: 0.55
Dividend: Approximately $0.50/share/year
Here are my assumptions:
I have $682 to invest. Trade costs will be ignored.
My fair value estimate for Nokia is $12.50.
My different alternatives, then, are to:
1. Buy 100 shares of the stock outright.
2. Buy a single option on one of the LEAPs and reinvest the cash in a two-year Treasury. The current yield on Treasury is 0.44%, which is is a negligible amount.
(I did not mention a possible third option, which would be to buy multiple LEAPs. In rare circumstances, with strong industry knowledge and high certainty, it may be appropriate to do so.)
So the three ways I tend to look at LEAPs are:
I. Determine the price to fair value of the LEAP on expiration, assuming it will reach my fair value estimate.
II. The account value on expiration assuming either bankruptcy or the stock reaching fair value.
III. The premium I am paying over current price.
I.Price/Fair Value
So I'll make this one simple. Relatively, which of the below, A-D, has the greatest margin of safety? For this, we just need to calculate the price to fair value for each one. I'll assume the fair value of the options as what they would be worth the day of expiration.
A)Nokia: 6.82/12.50= 0.55
B)Jan. 2013 5.00 Call: 2.46/(12.5-5)= 0.328
C)Jan. 2013 7.50 Call: 1.18/(12.5-7.5)= 0.24
D)Jan. 2013 10.00 Call: 0.57/(12.5-10)= 0.23
Right away we can dismiss the D) Jan. 2013 10.00 call. It only provides a slightly improved price/fair value over the Jan. 2013 7.50 call, with a greater likelihood of finishing out of the money.
Therefore, the option with the greatest price/fair value is C.
II. Model Testing with Extremes
As Warren Buffett has said, to evaluate a model, take it to its extremes. So lets evaluate the three remaining opportunities in the following scenarios:
1. Bankruptcy on the day of expiration.
A)Account value=Dividend received ($0.50/share*100 shares*2 years)=$100
B)Account value=Initial principal minus amount invested=$682-246=$436
C)Account value=Initial principal minus amount invested=$682-118=$564
2. Fair value on the day of expiration.
A)Account value=(($0.50/share/year*2 years)+(Fair value))*shares=$1350
B)Account value=(12.5-5)*100+$436=$1186
C)Account value=(12.5-7.5)*100+$564=$1064
3. Overall gain/loss for the two scenarios.
A)97: -85%= 1.1:1
B)74%: -36%= 2.1:1
c)58%: -17%= 3.4/1
C, then is the best choice for our second thought exercise.
III. The cost to borrow.
Premium paid= Strike+ cost of option+likely dividends-current price
A) No premium. Obviously, I have less flexibility as all my funds are tied up.
B) 5.00+2.46+1.00-6.82= 1.64. With 564 days left on the option, that's $1.00 per year.
C) 7.50+1.18+1.00-6.82= 2.76. With 564 days left on the option, that's $1.75 per year.
In this scenario, choice C is much more expensive than choice B.
Discussion:
At this point, the choice has come down to either option B or option C. Option B is more likely to finish in the money, and its risk to reward profile is comparable (although not as good) as option C. Although I would be risking an additional $121 for option B, I would still end up with the majority of my initial portfolio value under a severe deterioration in the company.
LEAPs are best for stocks that are either going to do much worse, or recover. This is why we try to buy LEAPs on underpriced stocks, which we expect will recover.
I'll finish this series with a quote in which Whitney Tilson discusses LEAPs:
"Whitney Tilson: We tend to buy LEAPS on very stable businesses where we think the underlying intrinsic value is growing around 10% annually, the multiple on the stock is likely to expand rather than contract and the options are cheap. Options on low-volatility stocks like WMT, MCD, BRK, MSFT and BUD are cheap and we own LEAPS on all of them."
Disclosure: I am long Nokia Jan. 2013 $5.00 LEAPS.
If you enjoyed these posts pleaseclick follow at the top left, or rate me below.
The Doctor InvestorAlso check out: