"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%.
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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.
