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:

Call: $730

Put:    333

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.