Stock Options To The Rescue! Leap Wireless (LEAP)
Today we’re looking at an option trade on Leap Wireless to get back to breakeven after a big decline in the stock.
Here’s what happened…
Leap Wireless (LEAP) reported quarterly earnings earlier this week. The shares are down 20% to around $4.42 after earnings fell short of Wall Street estimates.
Here’s the deal…
Leap Wireless provides pay-as-you-go wireless services under the Cricket brand name in the US.
Last quarter LEAP lost 54 cents per share. It was an improvement from the 85 cents they lost in the same quarter last year. But it fell short of the 50 cent per share loss analysts were expecting
Quarterly revenue increased 3.5% from $760.5 million a year ago to $786.8 million this year. They fell well short of the $836.3 million analysts were expecting.
Here’s the kicker…
When it comes right down to it, LEAP is losing the battle for customers with AT&T (T) and Verizon (VZ). They lost 289,000 customers last quarter alone. They just can’t compete with the deep pockets of these much larger competitors.
Yes, they have the iPhone 4s. But they don’t subsidize the purchase price like AT&T and Verizon. If customers want an iPhone on Cricket, they have to shell out $500. But they can get the same phone for only $200 with a 2-year contract at T or VZ.
What’s more, the average revenue per subscriber fell for the first time in nearly two years. LEAP is either losing their best customers or their customers don’t see the value in the services they’re offering.
Any way you slice it, that’s bad news for LEAP.
Here’s what to do now…
Let’s assume you invested $550 to buy 100 shares of LEAP at $5.50 per share before earnings. Unfortunately LEAP’s poor performance has sent your stock holdings down nearly 20%. At a recent price of $4.42 per share, you’re down about $108.
At this point, getting out of this LEAP trade at breakeven is about the best you can hope for. But if you simply hold onto the stock, you need the stock to jump 20% to $5.50 just to breakeven.
A 2:1 call ratio spread can lower the breakeven price. It’s executed by buying a call at a lower strike and selling twice as many calls at a higher strike.
Buy 1 LEAP October 2012 $4 Call and Sell 2 October 2012 October $5 Calls.
Right now, you can buy the $4 call option for $1.15 and you can sell the $5 call option for $0.65. So it doesn’t cost you any additional money to buy one $4 call and sell two of the $5 calls.
If LEAP is below $4 when the options expire in October, all of the call options will expire worthless. You’ll still own the stock and the loss on the stock is the same whether you buy the options or not.
However, if LEAP is trading above $5, the maximum profit will be realized. To calculate the maximum profit, assume LEAP is trading for exactly $5 at the October options expiration.
The $4 long call will be worth $1 and the two $5 calls will expire worthless. So you’ll make a $100 profit on the options. But you can also sell your 100 shares of LEAP stock at $5 per share. So, you’ll get $500 on the sale of the stock and $100 from the options for a total of $600.
Don’t forget, you originally bought 100 shares of LEAP for $550. Thanks to the options you were able to recoup all of your losses and then some with the stock trading at $5 per share.
In essence, you’re lowering your breakeven point from $5.50 to $4.75. You still have some upside if the stock rallies above $5. And the worst case scenario is you take a loss that’s equal to simply holding onto your long stock position.
In my opinion, a call ratio spread is a great rescue strategy to get you out of LEAP with a smaller upside move in the stock.
Good Investing,
Corey Williams
Category: Stock Options To The Rescue!
