Friday, February 7, 2014

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















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