I'm doing some research on LEAPS as a form of investing. I love the prospect of betting on out of favor stocks through LEAPS that seem poised for big changes, such as what Cornwall Capital did back in 2003 with their bet on Capital One rallying post-investigation. However, I don't understand the math. Simply, I'm confused. If Cornwall bought 8000 LEAPs priced a little more than 3 bucks on Capital One with a strike price around 40, how on earth did they bag 526,000 dollars after Capital One's stock shot up post-investigation, well past the strike price. It apparently was hovering somewhere around 30 when they placed their bet. Can someone please spell out the math for me on this one? Isn't each LEAP a total of 100 shares. How did 26,000 become 526,000?? I read the section in Michael Lewis's The Big Short, but I don't get the math. Can someone write out the exact arithmetic for me? I am a neophyte but am trying to educate myself on investment finance. Thanks so much!
I just looked up the passage in the book. It looks like they bought 80 LEAP contracts (each for 100 shares), at a 40 strike price, for a cost of about $26,000 (80 LEAPS *100 shares/leap * approx. $3.25). At expiration, those contracts break even at a stock price of 43.25, and every 3.25 thereafter they make another multiple of the initial investment. Before expiration they will be worth even more since there will generally still be time value remaining in the option. They cashed out at $526,000, for 20 times their initial investment, which if held to expiration two and a half years later would require the stock to be a little over 95. Capital One's stock price was in the 60s by September 2003 and hit the mid-80s by the end of 2004, well before the options expired.
Thank you so much for your response. I understand quite a bit more now on how to calculate the difference, but I did some calculations and am still a little confused-- 95.25 - 43.25 = 52 in the money 52 / 3.25 = 16 multiples so 16 * 26000 = 416000 dollar profit after exercising the LEAPs or 52 * 80 LEAP bundles * 100 shares per bundle = 416000 dollars where's the rest of the 526000 dollars--the 110,000 ? Did they exercise the LEAPS at a bit higher than 95, say around 13.75 higher, around 109?? That allows for the arithmetic to add up-- (109-43.25) * 8000 = 526000 Just trying to have as much clarity as possible on how this stuff works. Thanks so much for your help
Happy to help. I had accidentally used 30 instead of 40 for the expiration profit calculation, so you are right, at expiration to achieve that return the stock would have to have been around 105, which the stock never reached. The key thing to realize is that when they sold the options there was time value left, making them worth potentially quite a bit more than the intrinsic value (stock price minus strike price). This page may be helpful in explaining how call options are valued: http://en.wikipedia.org/wiki/Call_option
So, just to clarify a bit more--the options on Capital One that Cornwall sold are worth approximately stock price at time of sale minus strike price plus any time value left minus fees------They never actually had to buy Capital One's Stock at 40 in place of whatever it was worth, around 95 or so to make a quick profit on intrinsic value. The options could be sold at their intrinsic value plus time value to anyone who was interested in purchasing Capital One's stock at a discount price. Is this what occurred? When someone sells an option or LEAP for profit is this what usually happens---It's Stock Price - Strike Price + Time Value left over - fees ??? And they never actually have to exercise the LEAP by buying the stock it was contracted for---they can just sell the options for a quick profit? Sorry if my questions seem redundant. Thanks so much for any replies in advance