LEAPS Vs. Gold Stocks

Real-time Monetary Inflation (last 12 months): 2.2%

Last week really tested the mettle of metal-owners. An early-week bullish head fake was followed by some nasty selling that left COMEX spot gold nearly $31 an ounce lower for the week. Long liquidation was the name of the game on Wednesday and Thursday, but Friday the shorts rushed in. Well, maybe not rushed, but they weren't walking to get to the trading rings, that's for sure. Open interest rose nearly a percentage point for the week as shorts and longs passed each other at the doorway.

One reader decided to come through the door as a buyer on Friday. He wrote: "I bought a little Barrick Gold Corp. (NYSE: ABX) as a new position this morning at $33.77. I'll give it a short leash, though, since I have no idea if the price of gold is gonna plummet in the next few months. If it does, ABX is probably over-priced at these levels. Still, it did a nice little reversal today, so I can't complain."

Indeed, ABX did pull a nice reversal on the day. Opening a shade under $34 a share, the stock sold off to $33.65 before clawing its way back to a $35.83 close. Friday's price action was a rebound-the second consecutive rebound, mind you - off a key retracement level for the stock's March-December rally.

I wonder about the length of ole' Bob's leash (Bob's the reader, though I don't really know how old he is). Is he going to risk half his investment? Less? More? Would another volatility head fake be likely to take him out prematurely? I mean, what if the opposite of last week's scenario plays out-a sharp sell-off that sets up a bullish reversal?

Well, there's a way to keep Bob's capital commitment low-or, put another way, to keep his leash short-while giving him the staying power to ride out interim volatility. Instead of buying ABX, perhaps Bob should consider leasing the stock with an option purchase. In-the-money LEAPS-Long-Term Equity AnticiPation Securities-calls with expiration dates stretching out to January 2012 can be bought for less than half the stock's current price.

Call options, you may know, grant their owners the right, but not the obligation, to buy the underlying stock at the contract's exercise or strike price. Bob could have purchased the ABX $20 LEAPS call for somewhere between $16.55 and $17.40 a share near Friday's close. If his "little" investment in ABX was 100 shares, he'd have spent $3,377 for a cash trade in the stock. He could have taken an option on those 100 shares for something like $1,740 instead (that's actually 48.6 percent of ABX's closing price).

Note that the strike price of the LEAPS call is only $20 a share, even though ABX's market price is nearly $36. Having the LEAPS in his pocket gives Bob the right to purchase the stock at $20 at any time through January 2012. Since the option cost him $17.40 a share, his effective purchase price (and his expiration breakeven price) is $37.40 (the $17.40 call premium together with the $20 exercise price). Given ABX's historic volatility of nearly 52 percent (see "How'd YOUR Gold Stock Fare Yesterday"), a $1.57 move ($37.40 - $35.83) in two years doesn't ask much of the current market.

If ABX instead, tanked, the call's value would diminish, but even if ABX became worthless by January 2012, the maximum loss sustained by Bob would be the $17.40 premium, not the stock price.

And the upside potential? Well, deep in-the-money options behave like very much like their underlying stock. The delta for Bob's call presently is .88, meaning that a $1 change in ABX's price-all other factors remaining unchanged-would likely be tracked with an 88-cent shift in the option's value. Delta's not constant, though; it changes with the passage of time and in reaction to changes in the price relationship of the option to the stock. At the end of the option's life, the delta will rise to 1.00 if the option's in the money or falls to zero otherwise.

Even if the option falls out of the money before expiration-that is, the price of ABX falls below the call's exercise price-the option will retain some value. The premium represents the cost for the time remaining in the option's life and the opportunity it represents. At the end of the option's life, of course, that time value will have eroded away so that the option will be worth only its intrinsic value-the degree to which it's in the money.

Bob will have a decision to make at some point when the option's in the money: either exercise the call to obtain the underlying ABX stock or sell the option for its current premium.

Bob's concerns about the possibility of ABX being overpriced demands that he be cautious about exposing himself to capital losses. Using deep-in-the-money LEAPS calls as a substitute for outright position in the stock may be just the short leash Bob needs for his walk down Wall Street.

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