So maybe you bought Apple 20 LEAPs last November at $4 when Apple was around 20, and now Apple is around $32 and you have tripled your money (the January 2005 LEAPs closed at $12.60 and the January 2006 LEAPs closed at $14.80) – except that you sold half back when you had doubled your money, but now you have tripled your money on the other half – and you are getting nervous.
Should you take your profit?
Hold on to see how much higher it goes at the risk of losing it all?
If the stock neither rises nor falls from here, you come out ahead by holding on five more months until you’ve owned the LEAPs for a year and a day. (Say that, between federal and local income tax, you’re in the 35% tax bracket on ordinary income, but in the 18% bracket on long-term gains. And say you made $10,000 on these LEAPs. Waiting five months until your gain goes long term saves you $1,700 in taxes – a phenomenal 56% annualized compounded rate of return. [Isn’t math fun? Turn a quarter into twenty-seven cents in a week and you’ve grown your money at a compounded annualized rate of 5400% . . . and made two cents.])
But you know that if you do wait in hope of the favorable tax rate, the stock will fall and your profit will evaporate. This is how the gods amuse themselves. And yet if you take your profit here, those very same gods will send the stock to the moon.
I am not suggesting this is the kind of financial analysis we were taught at Harvard Business School, but you know in your bones I am right.
So one thing you can do is sell an equal number of Apple 32.5 calls. This sharply limits your profit, should Apple, defying Newton, soar. But that’s the chance you take in return for the premium you are paid for the calls.
Let’s say you bought 25 of the January 2005 Apple 20 calls at $4 each. (This is how options are quoted. Each call represents 100 shares, so you actually paid $400 for each call . . . $10,000 for 25 of them.
You sold 12 of them a while back for $10,000 and now are left with 13. So you sell 13 Apple 32.5 January 2005 calls for $3.40 each ($4,400 in all) and here’s what happens depending on where the stock is when the LEAPs expire on the third Friday in January:
THE STOCK TANKS between now and then. Well, in that case, aren’t you glad you sold the 13 calls? At least you get to keep the $4,400 premium (less 2005 ordinary income tax).
THE STOCK SITS WHERE IT IS NOW, $32.30. You still get to keep the $4,400 premium (who would exercise an option to buy Apple stock at $32.50 when they can buy it in the open market twenty cents cheaper?) . . . and you have a nice long-term gain of nearly $16,000 on your January 20 calls (13 calls x 100 shares per call x $12.30 = $15,990).
THE STOCK IS $40. You exercise your calls to buy 1300 shares at $20 which you promptly sell at $40, for a $26,000 long-term capital gain. And you buy back the calls you sold, paying $7.50 or so for each (because with Apple at $40, the right to buy it at $32.50 is worth $7.50), for a loss of $5,330. Net net, a pre-tax gain of more than $20,000.
THE STOCK HITS 90. Wait . . . I need to move my car from beneath your window.
See how this works?
By forfeiting all gain above 32.5 in return for that rotten, crummy, who-needed-it-anyway $4,400, you lost the chance of a lifetime.
So I’m not saying to do this; just that it’s an option. I’ve done it with my 2006 LEAPs (for which the premium on the calls I sold was $6.40). If Disney acquires Apple at 90 in the next 18 months (a nice fit, wouldn’t you say?), you won’t want to be around me.
1. Don’t do this with a full-service broker – the commissions are ridiculous.
2. Don’t do this at all. You’re supposed to be engaged in a prudent lifelong program of steady monthly investments via low-expense index funds. Remember? This column you come to for advice on which presidential candidate to vote for.
3. Have you noticed how guys like me tend to write about their successful suggestions and not their suggestions that have gone nowhere? We do this to keep you paying big bucks for our advice. Here’s mine: vote Kerry.
‘One thing that Buddhism teaches you is that every moment is an opportunity to change. And we will have a moment in November to make a big change.’ – Ron Reagan