As the stock on Ford dropped by as much as 1.43% midday on Thursday after the company announced its profit dipped by 56% in the third quarter as a result of slower sales in the U.S. and recall, investors can take advantage of the decline and buy it even cheaper. To bump up the effective yield, write a covered call LEAP going to 2018, said Ron McCoy, a portfolio manager on Covestor, the online investing company, and founder of Freedom Capital Advisors in Winter Garden, Fla.
"By writing the LEAP call against the long position, investors are lowering their risk and the trade off is they are giving away some potential upside" he said.
LEAPS are long-term options which offer an extended protection for the downside and more premium for the upside. Ford's current yield is 5.2% and by selling the January 2018 $9.75 call LEAP against their long stock, an investor could lower their cost from its current price of $11.77 to the low to mid $9 range, which is more than 15% off Thursday's price. The upside also is that investors will get the $0.15 quarterly dividend until the stock is called away at the lower cost basis, which increases their yield.
Ford has rebuilt its balance sheet by disciplined cash management over the past eight years, rebounding after the company was facing the possibility of filing for bankruptcy back in 2008 and 2009. The company now has tremendous cash flow and $11 billion cash net of debt, trades at 5.5 times trailing earnings and less than seven times forward earnings, McCoy said.
The company is expected to earn $1.80 in 2016 and $1.70 in 2017.
"While management has stated that they believe the U.S. market may be due for a slight correction in the near future, the market has been pricing in this factor for some time," he said. "Ford is approaching one third of the multiple on the S&P 500."
Investors who are seeking additional time to lower their risk buy LEAPS, which have a maximum maturity of 2.5 years and are less expensive than the stock itself, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla. Standard options only have a maturity of up to one year.
"LEAPS options are designed for investors to participate 'surgically' in the stock upside for a specific time period," he said. "If investors have a precise forecast on the stock return, say up to the next 2.5 years, they can use LEAPS to participate in just that part of the upside, but not on the entire future value of the stock."
LEAPS can also be used to hedge the underlying stock for a specific time period.
"If you own a stock that may be exposed negatively in the next two years, the premium of selling a two-year in-the-money LEAPS call will help offset the downside risk of the stock," Ma said.
LEAPS can be a crucial component of an investor's portfolio because it can lower the amount of money lost, said McCoy.
"More times than not, option buyers lose money and this is often due to poor timing," he said. "Buyers of LEAPS have significantly more time for the underlying stock or index to make the desired move and avoid 'time decay' or at least slow it down."
The longer an investor goes out in expiration, the price of the option becomes more expensive. Investors who sell LEAPS against their long position can also reap the benefits of selling the increased premium and reducing their risk, McCoy said.