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American International Group Inc: A Lesson in LEAPS and Delta

One AIG trader shows how LEAPS can be used as an alternative trading strategy, and why delta matters

by 8/6/2014 11:11:23 AM
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American International Group Inc (NYSE:AIG) has not traded north of $60 since the shares sold off dramatically in the last quarter of 2008, in the midst of the financial crisis. At last check, the stock was lingering near $52.40 -- about 2.6% above its year-to-date breakeven mark. This didn't stop one post-earnings option bull yesterday from rolling the dice in a big way on a move north of this round-number mark over the long term.

Taking a quick step back -- calls traded at more than seven times AIG's average daily pace yesterday, with 91,000 contracts on the tape at the close. A hefty portion of this activity occurred when two massive blocks of 19,621 and 11,373 contracts were bought to open on the same exchange roughly two hours apart at the stock's January 2016 60-strike call, near the respective ask prices of $3.25 and $3.15. If these blocks were indeed initiated by the same trader, she ponied up nearly $10 million for her bullish bet (number of contracts * premium paid * 100 contracts per share).

The trader's initial cash outlay for these Long-term Equity AnticiPation Securities (LEAPS) also represents her maximum risk on the trade, should shares of AIG settle south of the strike at January 2016 options expiration. Gains, meanwhile, are theoretically unlimited, should the stock be sitting north of the breakeven marks at expiration, with breakeven calculated by adding the strike price and the premium paid ($63.25 and $63.15, in the case of yesterday's call buyer).

By purchasing options with such a long shelf life, this trader could also be using the contracts as an alternative to buying shares of AIG outright. Specifically, if she bought 3.1 million shares of AIG (the rough equivalent to the number of shares controlled by the January 2016 60-strike calls) at $52 apiece -- near where they were trading at midday on Tuesday -- her initial cash outlay would have been $161 million. In other words, although she is unable to participate in shareholder benefits such as voting rights and dividend payments by purchasing options, she will be able to benefit from the stock's uptrend, with less capital on the line. Additionally, her risk is capped at the premium paid, as opposed to the chance of unlimited losses by owning the stock outright.

As far as the value of the option, delta for the January 2016 60-strike calls closed at 0.37 at last night's close. At the most basic level, this means that the options market is giving the call a 37% chance of being in the money at January 2016 options expiration.

More specifically, for every point AIG adds over the next 17 months, the value of this call will rise $0.37. Conversely, for every point American International Group Inc (NYSE:AIG) loses, the value of this call will drop $0.37. However, the factor of delta is fluid, and can change over the course of the option's lifetime. The ultimate goal is for delta to reach 1, at which point the call will be delta neutral, and move in step with the underlying equity's price.

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