Wed Mar 22, 2006: Solar Energy LEAP Income (NASDAQ-ESLR)

Solar Energy stocks have been hot over the last year. For income-oriented investors who want to participate in this sector without the full risk of just buying the stocks, selling LEAP call options might be of interest.

Long-term Equity AnticiPation Securities (LEAP's) are like ordinary call options but for longer periods of time, many months or even years. By selling this longer-term type of covered call, you receive more income up front, which reduces your risk of owning the stock compared to selling a shorter-term covered call.

The tradeoff is that the percentage income on a monthly basis is lower. For more conservative covered call investors this is often a worthwhile tradeoff because they prefer to have less downside risk and a more certain return over a longer period rather than a high one-month income but uncertainty for the upcoming months.

You can read more about LEAP's here. There are both LEAP puts and LEAP calls. We'll discuss LEAP puts in future commentaries.

Evergreen Solar, Inc. (NASDAQ-ESLR) has consistently provided above-average option income for covered call investors over the last year.

Let's compare two ESLR LEAP's, the January of 2007 call with a strike price of 12.50 and the January of 2008 call with a strike price of 10.00, both of which are in-the-money-calls.

The Jan07 12.50's offer a return of 25.4% over the next 10 months, or about 2.5% per month, as long as the stock is at 12.50 or higher at expiration Friday January 19, 2007.

The Jan08 10.00's offer a return of 37.6% over the next 22 months, or about 1.7% per month, as long as the stock is at 10.00 or higher at expiration Friday January 18, 2008.

By the way, note how much higher the one-month return of 4.4% is for the April 15.00 call even though it's out-of-the-money. But let's return for now to our LEAP comparison for more conservative option writers.

Quick Quiz #1: What are the downside break-even points for each covered LEAP?

Answers:

$9.97 for the Jan07

$7.27 for the Jan08

Remember we're purchasing the stock at $14.17 per share in either case. Since the income from selling the Jan07 call is currently 4.20, the stock would have to fall below 9.97 at expiration to cause a loss. Since the income from selling the Jan08 call is currently 6.90, the stock would have to fall below 7.27 at expiration to cause a loss. Obviously this makes the Jan08 the safer choice.

Quick Quiz #2: Below what points, though still profitable, do the net returns start to become less than the percentage assumed based simply on the premium received?

That's easy:

below $12.50 for the Jan07

below $10.00 for the Jan08

Even though we're purchasing the stock at $14.17 per share, the stock can go down as far as the strike price without affecting our percentage income at all. That's the beauty of selling ("writing") in-the-money calls, they are safer than at-the-money or out-of-the-money calls because they provide more downside price protection.

It's not just about the highest theoretical return; it's also about the practical risk.

Again, viewed this way, the Jan08 is safer. If I had to choose, that's the one I'd prefer to write. At 1.7% per month (approximately 20% per year) it's still quadruple the yield available from most C.D.'s currently available, and that's plenty good enough for me.

One more point, to review once more the percent return calculations for in-the-money calls.

The Jan 07 call is in-the-money by (14.17 - 12.50 = 1.67) so the actual time premium received is 4.20 - 1.67 = 2.53

The net amount invested per share is 14.17 - 4.20 = 9.97 because the option income is deposited immediately at the beginning of the option term, not at the end of the term like for C.D.'s

Thus the percent return is 2.53 / 9.97 = 25.4%

Now see if you can correctly calculate the 37.6% return for the Jan 08 call. It's important to be able to do these calculations in order to compare the choices available to you.

Until next time, best of luck with your option investments!