Leaping Ahead

Recently Stephen Todd pointed out that since 1900 there have only been three times that the stock market has risen five consecutive years up until now: the '20s, '40s, and '80s, which did not end well! A fourth time it rose 9 years - 1990s (say no more). For this reason it seems logical to assume a sideways to down market-strategy would be prudent. I also thought this in May 2009, when I started testing my DITM (deep-in-the-money covered call) hedging strategy, which happened to coincide with the recent 4th five-year up market, although my test account actually rose 11% per year for 4 years, then flatlined due to poor/early sector selection and low option Volatility caused by the Up market. It also increased the cushion from being 5 to 10% in the money protection, to much higher, for which I am now thankful.

With a higher likelihood of stocks now moving sideways to  down for the near future, an even more prudent strategy is being tested - one that a client successfully employed several years ago when I was a senior option trader (ROP) with Charles Schwab. This client would turn the tables, so to speak, from being the "patsy" in the game to being the House, or casino - by selling options rather than speculating on potential direction. The concept is to buy a quality stock in the $5 to 20 range that has LEAP options and sell a covered call (never a "naked" one), and simultaneously selling the same year Leap put- both slightly out of the money.

Normally one can immediately bring between 1/3 and 1/2 of the funds spent on buying the stock, providing a better cushion than the above DITM plan; although being similar to it, the Safety and Reward are both considerably higher, and the monitoring is almost negligible for about two years- at which time the options expire. Although potential annual double-digit profits are likely, direction is not important, but being called away at expiry does increase the return.

Since one year ago I have amassed a Leap portfolio of 20 positions, mostly done recently.

As with any investing strategy there are Risks attached:     

Below is the logic of the strategy with a theoretical example, and the "Visible Hand" of five fingers ( A through E) of what can happen over time.

As with "E", more stock can be put to the investor - so they must want to own the stock.

	**Worst case:		Stock gets taken over or involved in merger - adjusted options
			gets complicated, but no loss involved; XYZ goes bankrupt: 1 in 1,000
			Profits on other 15-20 stocks make up for loss.
	***commissions not included; stocks bought in IRAs, etc. must sequester Max Loss(e.g.$700)
			In IRAs, profits become 8%: and 11% annualized (if called away)
			If repeated every two years, no stock cost - profits much higher.
	A Strangle is just a Straddle with different prices for calls and puts

			THEORETICAL	LEAP	STRANGLE
	STOCK:	XYZ	$9					DEBIT	CREDIT
	Buy 100 shares of XYZ at $9.00							$900
	Sell 1 LEAP covered call -			Jan.2016 10-strike price @ $1.20					120
	Sell 1 LEAP put-Jan. 2016 7-strike price @ $.80								80
	4% Dividend; 9 quarters @ $9/Q=								81
							TOTALS:	900	281
	% Profit:	31.22%
RESULTS	Ann.%:	14.40%	(over 12 months, not 26)
A	HomeRun:		If stock called away at $10 in Jan.2016				$281+100=381
	% Profit:	42.33%
	Ann.%:	19.54%
B	Stock settles at $10 on expiry-			Maximum profit, repeat NEXT two years				raise option strike prices.
								call:11	put-:9
C	Stock stays the same: $9			Maximum profit, repeat for two years
	* If stock falls to $7 ON Jan.21, 2016 - Keep $281, resell 2 more years out (loss of $200 on XYZ).
D	BUT-	Sell $6 put; sell $8 call (2018)			No cost for stock this time!!
E	*Worse Case: Stock falls BELOW $7 put strike price ON Jan.21 2016:
		100 shares of XYZ are "put" to you; repeat D