Looking at LEAPs Strategy

Reader Barry P. posed the question of what to do with LEAP options that have moved deep into the money and are approaching their expiration date. Specifically, he owns calls in Google (GOOG - commentary - Cramer's Take) and Chicago Mercantile Holdings (CME - commentary - Cramer's Take), which are both more than $100 in the money and are set to expire Jan. 19, 2007.

He is planning on exercising the calls and taking the stock to avoid a large tax bill that would be incurred if he sold out the calls and booked the profit. The problem is that both stocks trade near the $500 level, and a purchase of the underlying shares would require significant capital or incur a large margin requirement on which he'd likely be charged interest.

One approach might be to consider writing some out-of-the-money calls against any stock purchased through exercise to create a covered position. This would not help avoid a taking a tax hit on the sale of the stock, but it could help reduce some of the risk of owning the shares and reduce the margin requirement.

Many firms are now offering portfolio margining to qualified customers. Portfolio margining basically means that the firm will take into consideration offsetting hedges against a stock position for calculating the margin requirement. For individuals, this is mostly applicable to married puts (long stock/long puts) and covered calls and can often bring the margin requirement down to around 15% of the stock price. That is well below the typical 50% margin requirement.

The covered call will help reduce risk and provide some incremental income, while selling a call whose strike is some 20% out of the money will leave plenty of room for further stock appreciation.

For example, with shares of Chicago Mercantile trading around $535, you could sell the January 2008 LEAP calls with a $650 strike for around $40 per contract. That gives you about 7.5% of downside protection or potential income if the stock is flat for the next year. It also leaves room to earn 27% should shares rise above $650 in the next 13 months.

ALL STEVEN SMITH BLOG ENTRIES | POST A COMMENT | READ COMMENTS  

---

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

To read more of Steve Smith's options ideas take a free trial to TheStreet.com Options Alerts.