Going back to the original example, which was based on XYZ trading at $100, with an implied volatility of 50%, the table below compares the theoretical call strike prices that would equal the value of $100, or an at-the-money put option across one- and two-year time periods, and 2% and 4% short-term (one-year borrowing cost) interest rates.
As you can see, if the annualized cost to borrow money moved from 2% to 4% and the life span of the position was two years, you could sell a call with a $120 strike price for the same price as the cost of buying a put with the same expiration and a $100 strike price. This would mean you'd created a position that removed all downside risk and yet offered a potential upside of 20%.
While these numbers are theoretical and don't yet reflect current yields, they illustrate a useful strategy for options investors to use if we move to a higher interest rate environment. Owning a stock that has no downside risk, but a 20% profit potential over a two-year period, certainly seems like a legitimate alternative to parking money in a two-year note that earns 5%, or even 8%. But this carries the short-term risk of loss of principal, should rates rise and you need to sell the bond before maturity.
|The Highest Call Strike that Equals Cost of At-the-Money Put |
|Expiration Period||2% Interest Rate||4% Interest Rate|
|One Year LEAP||107||110|
|Two Year LEAP||114||120|
|Source: TSC Research|