Leverage QQQ With Options For Twice The Upside, Half The Downside

Sep.21.11 | About: PowerShares QQQ (QQQ)

My previous articles discussed several different ways to provide inexpensive Portfolio Protection. All those strategies made one basic assumption: that the investor was not looking for new investment opportunities, but rather hedging his current portfolio (a defensive posture).

This article will deviate a little from that theme. It is my intention to illustrate an option hedge strategy for instituting new investments (an offensive posture). Not all stocks are a candidate for this strategy. Since I will be buying or selling options, the pricing characteristics of the option are in the forefront.

For instance, the Financial Sector ETF (NYSEARCA:XLF) is currently trading at $ 12.55. Options on XLF are in $1 increments. The spread between strike prices is nearly 8% of the underlying. So it’s difficult to get in tight and navigate with the precision that is needed.

On the other hand, SPY, which is trading around $120, also has $1 option increments. In this case the $1 spread between strikes is only about 0.83% and allows precision. Another example is Apple (NASDAQ:AAPL), which is trading above $400. The increments between strike prices are $5, but this still results in a relatively small spread of about 1.2%. There is no hard and fast rule, but I must draw a line somewhere, so I avoid this strategy if the security’s incremental option spread exceeds 2%.

Rather than pick a particular stock, or use SPY as in my previous articles, I’ll use options on the Powershares QQQ Trust. The current price of QQQ is around $56, and the $1 increment means my spread is somewhat less than 2%.

First things first: How much do I want to invest? To some extent, this is a trick question. If the investment is fully hedged and I have limited downside risk, I can be aggressive. What I have been comfortable with is doubling what my un-hedged purchase would have been.

So, for this example, I might have invested $25,000 un-hedged, so let’s make the hedged investment around $50,000. First I buy the hedge -- a long-dated, at-the-money put. Unlike my use of long-dated options for portfolio protection 12 months out, I shorten it somewhat here. My reasoning for using a shorter-duration put is that when I look to avoid loss, I want to avoid loss all the time. When I look to make money, I want to make it fast and then re-evaluate.

So I’ll go with the June 2012 option with a strike of $56. This costs $5.60 per option and the protection costs $5,600, a whopping 10% of my planned investment. I will deal with this cost shortly.

The second step is going long the QQQs. I could either buy the ETF or sell puts. I prefer to sell puts, as this method uses less cash and margin, and I can pick up some theta gain by managing the strike price. On the other hand, an outright buy of QQQ shares doesn’t require as much maintenance.

The third step is selling near-term puts to reduce the cost of the protective put. Before I can determine the strike price and number of options to sell, I must first break down the cost of the protection. The ten June puts cost $5,600. This is 39 weeks away, so the weekly cost is $5,600/39, or about $145. It is my plan to sell uncovered puts on a weekly basis to offset this cost.

If I was defensive I could cover these puts and buy more protection. Since I’m taking an offensive position, I am willing to accept some risk, so I’ll throw the dice on this a little. This additional risk gives me some additional flexibility in selecting the strike price of the puts I’m about to sell.

Since my target is $145 per week, I can either sell fewer puts at a higher strike or more puts at a lower strike. I generally choose fewer puts to minimize my risk. I generally pick the number of puts so that my risk exposure is 50% of what I would have invested without this strategy.

Since I would have invested $25,000; I’ll sell puts with risk exposure of $12,500. Two puts would just about equal that (2 times $56 times 100 equals $11,200). Next week's at-the-money puts sell for around 75 cents, so the two will generate $150, right where I need to be. I will continue this process every week. If the QQQs go down, this is my risk.

Let’s recap:

  1. I have invested $50,000 in the QQQs (either with shares or short puts). I have fully covered this position with June 2012 puts.
  2. I will recover the cost of the June puts by selling weekly puts. These will be uncovered and represent potential risk. But it is only half my unstrategized investment.
  3. I stand to gain twice what my unstrategized return would have been, and my risk is one-half.

Now that the whole strategy is on the table, I’d like to expand on to why I choose to shorten the long-dated put’s expiry date. Time decay is your friend when you sell an option and your enemy when you buy an option. The further out the expiry date, the slower the decay, so long-dated purchases provide a better cost structure.

On the other hand, this strategy does incur some risk and offers leveraged upside. If QQQ moves my way, I don’t want to hold the position so long that the trade then reverses and I lose what I was trying to gain.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in QQQ over the next 72 hours.

Additional disclosure: I may also buy and sell QQQ puts or calls or AAPL puts or calls.