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Registered investment advisor, dividend growth investing, ETF investing, long/short equity
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The Proposition

Wouldn't it be nice if you could limit your downside risk in the market while having a better than 90% chance of making very high returns? Well, if you are willing to be an active investor - and get down and dirty with options - you can. The nice thing about the strategy is that you are using a hedge that limits your losses in the cases of that freak "Black Swan" event that happens every 100 years or so. In that worst case scenario, with a proper hedge you can limit your downside to a loss in the 5-10% range. The likelihood of that happening? Pretty likely once every hundred years, very unlikely in other years.

The Rationale

At the basis of this strategy are two realities about options:

  • The majority of options never get exercised, so call writers (as opposed to buyers) most often are winners.
    • I've heard it quoted over and over again that 85% of options never get exercised if held to expiration. Based on my trading experience, that number seems to be too high, but there's not a doubt in my mind that the majority of options never get exercised. What this means is that call writing strategies - as opposed to call buying strategies - have a statistical, systematic bias in their favor.
  • Options are just like bubble gum. You want to buy them wholesale and sell them retail.
    • All right, I'm dating myself now. But when I was a kid pulling up my bike at the 7-11 to stock up on my favorite Bazooka bubble gum, it didn't take me long to realize that it was a way better deal to buy a package of 100 pieces for $1.00 than to buy them piecemeal at a nickel each.
    • Take AAPL mini-options today. An at the money put good until Jan 16, 2015 will set me back $66.95. That's about 61 weeks from today. If I look at today's at the money put, I can sell it for $6.55. If I were able to sell that put 61 weeks in a row (until my leap expires), that would bring in $399.65.
    • What this means, is that there is money to be made by hedging a position with a long protective put or call, and selling options on that position as frequently as possible.

The Guts

Let's say you think the stock market is going to go up in 2014, but not more than 20%. That would be my take for the year going forward, so let's use that as a starting point.

Let's also say I'm not willing to take more than a 10% loss, and I really - really don't want to have any loss at all. So I set up a hedge that ensures that a loss really can only happen if the stock market shoots up on a number of days by a total of more than 5% - in an overnight gap - without ever dropping lower and allowing me to reestablish my long positions.

I buy 10 shares of the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) today at a cost of $176.27 a share for a total of $1762.70. Because I don't want to lose money if I'm wrong, I buy a long term put, expiring Jan 15, 2016, that gives me the right to sell the SPY at $185, $8.73 more than I paid for it. This will cost me $19.24 for each share, times 10 for the mini-put.

So I'm out of pocket another $192.40 for a total outlay of $1955.10. By establishing this hedge, I can always sell the shares at $185, having paid $176.27 for them, or a profit of $8.85 on each share. Of course if this is all I were to do, I could still lose money, since it cost me $19.24 to buy my guaranteed minimum sale price. But I cannot lose more than $10.39 or 5.6% of my outlay.

I generate the profits from the strategy by selling my puts "retail" - as many times a year as possible for the maximum profit. Each stock has a different calculation to maximize profits, which we won't go into here. But for SPY, a simple solution that works is to sell weekly CALLS (expiring 1 week away from today) at a strike price $2.00 away from the current price.

Three things can happen to SPY over the next weeks and months, and two of the three require action on the investor's part:

  1. SPY can move up within the week to a point higher than your strike price
    • In this case, it is imperative that you reestablish a long position immediately. If the option is exercised on you prior to expiration date (rare occurrence), you simply buy at the current price and write a new call option $2 away. If the price exceeds the strike price, but the option has not been exercised yet, you should immediately roll the call up, buying the call back and reselling a call $2.00 higher. This latter move will cost you more money than you originally collected on the call premium, but will maintain your original price basis on the security, while still being profitable due to the capital gain on SPY.
  2. SPY can move within a narrow band during the week, never exceeding the strike price.
    • Do nothing. You keep the premium when it expires worthless in a week.
  3. SPY can drop down by more than $2.00.
    • In this case, to maximize earnings, you would roll the option down. This entails buying back the called option for less than what you originally sold if for, and selling a new call option. This results in a net credit.

The Results

The mileage you get out of this strategy will vary from period to period, going up in periods of high volatility of stock prices, and down in periods of low volatility. Due to the difficulties in obtaining weekly options price data on a minute-by-minute basis going back several years in time, it is impossible to track "what-if" scenarios using this strategy to a fine level of detail.

However, using historically accurate stock data and existing volatility histories for the SPY, it is possible to calculate the approximate gains achievable by this strategy. First, let's look at historical volatility today, and in 2011, when the market displayed high levels of volatility. Here are the two corresponding graphs.

(click to enlarge)

The above graph shows you that our current volatility level is just a tad below its historical average for the year of around 0.12. Compare that to a year of 2011, when volatility averaged about 0.22, and peaked to as high as 0.55, five times today's levels.

(click to enlarge)

What this means is by using today's options pricing levels, which are on the low side, we can be fairly sure the results obtained running our strategy today will likely be even better in times of high volatility.

The image below shows a rough statistical measure of average weekly price ranges on the SPY.

(click to enlarge) click to enlarge

Over the last 3 years, we've had about 49 weeks in which the stock ended higher than a $2 out-of-the money strike, 97 weeks when it ended flat (within a $4 range) and 29 weeks when it finished more than $2 below the weekly start.

Here's a "back of the envelope" calculation of the profitability of this hedging strategy on the SPY on average over that 3 year period:

  • 40 weeks options $2.00 away is exercised and rolled over : average up move 4.40
    • profit: 40 x ($4.40 - $1.28 ) = $124.80 / 3 years = $41.60
  • 97 weeks flat : 97 x $0.22 = $21.34 / 3 years = $7.11 per year
  • 29 weeks prices drops below $2.00 and we roll over option, which then expire worthless
    • profit: 29 x $0.27 = $7.83 /3 years = $2.61

Profitability of hedged call strategy over 3 years:

$41.60 + $7.12 + $2.61 = $51.33 x 10 units in mini-option$513.30
Less approximate trading costs of 56 yearly trades (discount broker)- $56.00
net results:$457.30
Net results: % of original outlay of $1955.1023.3 %

This is a remarkable result when you consider that you did not even have to be right about the direction of the market to still make double digit returns. Whether the market moves up, down or sideways, you can make money!

The most money is made if the market moves up or down a lot as opposed to channeling sideways in a narrow range, but all three market situations can be profitable.

The Risks

In investing, there's no such thing as the sure bet. There's always risk to every strategy. If you haven't found any ways to lose money with the strategy, then you've missed something. Go back and check your assumptions again. Our leap secured options strategy has two sources of risk:

  1. One or more serious gaps up - all happening overnight whether in subsequent days or in intermittent fashion over the course of the year - could cause this strategy to lose money. For the gaps to seriously impact the profitability of the trade, the total amount of the gaps up would have to supersede the $8.73 built in intrinsic value of the option ($185-4176.27).
    • By setting our prices $2.00 away from our original buy price, we are covered for overnight gaps of up to $2.00. Gaps up over that happen very infrequently, which is why we set our strike prices there.
    • By setting our gaps at $3.00 above we could further reduce the risks, but we would incur significantly less option income on average.
    • As the graph below shows, the biggest gap up in 2013 was on New Year's Day, and came to $2.66. In this case, $0.66 cents was "left on the table" before we could reestablish positions. This would have to occur on 13 different occasions to cause our strategy to lose money. Yet in the last 5 years, the reader will be hard-pressed to find more than 2 or 3 such occasions in any given year.
  2. A neglectful or incompetent maintenance of the covered options positions can result in a loss.
    • Why? Let's say the first call option triggers on the fourth day, and the investor fails to take note of that. So he never goes long the stock again. If the stock moves to say, $190 just towards the expiry of the long put option, in Jan 2015, that put option will have little time value left in it (extrinsic) and no intrinsic value, since it is now "out of the money". If the investor had re-bought the stock when first called off him, he could sell that stock at a profit at the current market price. Yet he no longer owns any shares!
    • This strategy is only appropriate for active investors or their advisors, who are able to monitor positions on a daily basis. The investor must also understand how to roll options over, and be familiar with the ins-and-outs of not always settling for the market price on wide bid-ask spreads.
  3. High trading costs, such as those encountered through the major trading houses.
    • Remember, you will be trading probably a minimum of 54 transaction a year, and possibly more. If your minimum trading costs are around $50 - such as many full service brokerages charge their customers - your trading costs will more than devour all profits!
Source: Leap Secured Options Writing - The Ultimate Safe Investment Strategy

Additional disclosure: Investing in options can be a risky proposition, especially for the novice investor. Consult with a professional broker or RIA before attempting any of these strategies.