Wednesday, May 21, 2014
LEAP OF FAITH
"Into every life a little rain.....". Or - Why I like hedging stocks with LEAP options (Longterm Equity AnticiPation) calls and puts that expire in January of future years - 2105, 2106, etc.
The strategy involves buying a stock of better than average quality ( A or B in the Schwab rating system), with or without dividend, with a price usually between $8 and $20; then SELLING a LEAP put and call, out of the money (called a LEAP Strangle - the same option price would be a Straddle- using the decay of the option to bring in money to hedge any losses. The trade-off or liability of selling these options is - the call limits any profit above the higher OTM (out of the money) "strike" price; the lower OTM put makes one liable to take on more stock, for which sequestered money must be set aside - Cash in an IRA, margin from stocks in a taxable account.
Here is an example of a major loss in one of my accounts, which should be offset with the double-digit returns of successful LEAP trades:
Just Energy was bought in November of 2013 at just under $7 ( 1000 shares for $7000 plus commission). It recently tanked from just above $8 to its current $5 level, a $3000 drop, or loss - $2000 from its original price.
However, by selling 10 calls at 7 1/2 for 2016, and 10 puts at $5, much of this loss was wiped out.
The call was bought back at: $312; it was sold originally for $1,042 (all commissions included). At the same time the 5-strike put was sold at $1.55 each - 10 cost $1,533.
Due to time decay of the options , the put can be bought back at $1.20 ($1,200) for a $333 profit, despite JE's dramatic fall. The stock can be sold ( a stop loss has been put in at $5.70) for $5700.
So instead of a $2000 loss ($3000 from its top), the numbers are:
Dividends: 6 times $50 (after foreign taxes): $300
Sold stock: $5700
Actual profit (if JE goes lower and gets stopped out) +$63 - not bad for a Torpedo!!
As for the total LEAP portfolio in this account (6 stocks including JE), as of May 1 - six months into the strategy ( excluding NOK, which was bought a year earlier), it is up 12%, or, if annualized for 12 months, using a 5 month average holding period, 29%.
As for MY personal accounts using LEAPS, also stating with one position in Dec. 2012, adding ladderlike monthly up to over 20 positions currently, I recently closed out my first and only position - as it turned out, prematurely - Trina Solar, a rather risky, Chinese company that looked technically weak, declining fro its recent high of over $18/share to $10! Today it jumped up over $3.
Still the potential "Loss" was ameliorated by the LEAPS, as follows:
Bought 500 shares in August of 2013 just under $9 a share ($4500), selling a 10-strike call and a 7-strike put. When TSL jumped from 8 to 18, I tweaked, or fine-tuned it by rolling both the put and call higher and farther out in time - 2015 to 2016 for more "insurance" money, which I returned when it dropped to 10.
Bottom line, the numbers went:
Stock cost: $4500, sold at $10.45 for $5215 - net $715
Unfortunately, by buying back both puts and calls after a downturn, the IV (Implied Volatility - which is the key in deciding what to sell - or buy back) was so high, I actually paid more to close out the options - $450- despite the rollup, out and time decay !! Another negative of TSL is the wide Bid-Ask spread; wise to avoid in case of buybacks.
So after holding TSL for 9 months (no dividends) my net profit (no loss) was $260, or 5.8% - annualized if held 12 months, 7.78% - not bad for a loss - better than MMFunds or CDs.
In conclusion, what I really like about the LEAP Strangle is the high reward with a hedged risk, and very little monitoring until the Leap expires. If the stock then settles lower (or higher) another "Collar" of Leaps can be put on for another two years.
Posted by DITMcalls at 12:08 PM