The General Electric play
One way to play the pending bankruptcy of General Electric is to purchase LEAP puts. In a registered account (RRSP or TFSA) you cannot short stock directly, however you can purchase PUT contracts. A few weeks ago you could purchase the January 2012 $17.50 puts for under $3.25 per contract. Last week you could have sold those put contracts for $4.70 for a nice 45% gain in just two weeks. However I recommend that you hold out for more.
There are two types of equity options, calls and puts. A call option gives its holder the right to buy an underlying security, whereas a put option conveys the right to sell an underlying security. The option also spells out the price you can buy/sell the security and the date that the option expires.
Essentially you are agreeing to (for a CALL) buy shares of a particular company for a set price anytime into the future up to a particular date. For a PUT you are agreeing to sell shares of a particular company for a set price anytime into the future up to a particular date.
Long-term AnticiPation Securities, or LEAPs, are just longer term options. You can exercise them any time you wish (up to the expiry date) or trade them just like you would any common shares through your broker.
So if you had purchased the LEAPs contract mentioned in the first paragraph you would be agreeing to sell General Electric common stock for $17.50 per share. And you would be agreeing to do this anytime you would like between now and January 2012. You would have paid $3.25 per share for this right.
Since each contract controls 100 shares your purchase price would have been $325 per contract plus brokerage fees. If GE stock drops, between now and January 2012, below $14.25 then you realize a profit from the contract.
Say the stock falls to $12 by January 2012. You could exercise the contract by buying GE stock on the open market for $12/share and immediately sell it for $17.50/share. Remember this contract cost you $3.25/share so your profit would be $17.50 minus $12.00 minus $3.25 equals $2.25 per share. (Not including brokerage fees).
Now imagine if GE stock went to $0.01/share. Now calculate your profits.
Alternatively, you could just sell the contract to someone else. In the above example you wouldn’t make the full $2.25/share but you wouldn’t have to outlay the capital to buy the GE stock and then exercise the contract by selling the GE stock. Simply selling the contract is much easier and less of a hassle.
The advantage of purchasing a LEAP contract rather than a regular option contract is that it gives you more time to be right. It gives you more time for GE to go bankrupt.
Each option or LEAP has both intrinsic value and time value. With GE stock at $12/share the intrinsic value of the put contract is $5.50 (since you could exercise the contract and realize a profit (or be ‘in-the-money’) of $5.50/share). However there is also a time value that can be added to the price of the option. Generally speaking, the more time there is before expiration the greater the time value of the contract.
Therefore, if GE stocks drops this year or even early next year not only will you be able to realize a handsome profit much sooner, that profit will be much larger too (since it will include the intrinsic AND the time value of the contract).
General Electric stock recovered slightly last week and these LEAP contracts can now be purchased for approximately $4. On any further strength in GE stock this next week, there might be a buying opportunity to take advantage of GE’s impending bankruptcy.
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June 10th, 2010 at 11:43 PM #
Genial dispatch and this fill someone in on helped me alot in my college assignement. Say thank you you for your information.
ross
June 11th, 2010 at 12:08 PM #
Glad I was able to help with the college assignment! Let me know what your grade was. Hopefully you can earn a little extra money on the GE play as well.
Best of luck, Ross