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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Leverage: Live by the Sword, Die by the Sword?  7 comments
    Aug 12, 2011 9:08 AM | about stocks: MET, PRU, HIG, AGO, SPY, XLF

    Running a portfolio that makes heavy use of deep in the money LEAPS for leverage, sometimes I have to ask myself, with leverage working in both directions, is the going up worth the coming down? 

    I do a certain amount of market timing, progressively adding to a hedge at set intervals in a rising market, and progressively liquidating the hedge in a down market. Also, I will take profits or sell covered calls when I think the market is high, and add to exposure when I think it's low.  But market timing is an uncertain process.

    Earlier this week as the market made lower lows I continued the process of rolling LEAPS down, extending it to apply to high beta financials such as HIG, MET, PRU and AGO.  A sample trade:

    Buy to open 5 HIG Jan 2012 17.5 calls @ 3.68
    Sell to close 5 HIG Jan 2012 20.0 calls @ 2.28

    Net debit of 1.40 for a 2.50 spread, rolling, stock stood at 19.43

    The thinking is, with volatility high, the sale of the 20 calls which are more or less at the money is a good trade, for the lower strike of 17.5 there is less time value, so the trade takes advantage of the volatility.  It's also undemanding, in that it will be profitable if the stock stands still. 

    If the stock goes back up, and volatility decreases, it will be possible to reverse the trade, receiving a net credit of 2.20 or 2.30 and liberating the cash for other uses. A profit from a round trip. 

    The roll down process requires the commitment of cash.  Some of the funds came from liquidating hedges, puts on XLF and SPY bought when the market was higher and volatiltiy was lower. The remainder came from cash reserves, also from the sale of a few low beta positions that had done well during the decline.

    I'm short puts on MET, PRU and others that became a problem.  I underestimated the severity of the potential downdraft and elected to sell puts as a source of time premium.  The puts began to develop increased maintenance or margin requirements which decreased the resources available to increase exposure at the bottom. 

    The test of this activity will come if and when the market gets back to its prior high.  Peak to peak this is supposed to result in about 10% profit, more if the stock picks are good.
    The last time there was a market event of this severity, that would be the mini-crash last year, this approach eventually showed large profits, enabling excellent performance for 2010, an IRR of 45%. 

    The leverage provided by deep in the money LEAPS, when covered calls are sold against the position, is asymmetrical. A portfolio of this type position will do extremely well in a market that goes up 8% or 10%, or even in a sideways market. It underperforms at both the extreme high and low ends. As a practical matter, I was operating along these lines during the financial crisis and it didn't blow out my portfolio, so believing as I do that that the market will go up 11% or better on the general average for the next several years, I plan to stay with the LEAPS diagonal strategy, long in the money LEAPS calls and short out of the money calls with shorter durations.

    I think selling the puts improves things long-term, but where it was problematical under extreme conditions I plan to do less of it going forward.

    Stocks: MET, PRU, HIG, AGO, SPY, XLF
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Comments (7)
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  • XTigerX
    , contributor
    Comments (315) | Send Message
    Excellent article Tom.


    One thing I was thinking every day this week "seems like a great week to buy options and a terrible week to be selling them". All of those stocks that gapped up and down this week giving options sellers zero seconds to buy back....ouch.
    12 Aug 2011, 09:26 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » I was watching a lot of investment TV, most of the options people were suggesting to sell them to take advantage of volatility. As you say, the nimble were at an advantage, whether they were buying or selling.


    Not being nimble, I tend to buy and sell at the same time, selling higher time premium and buying lower time premium, always betting my opinion of long-term direction.
    12 Aug 2011, 09:39 AM Reply Like
  • Rookie IRA Investor
    , contributor
    Comments (2881) | Send Message
    It´s a very interesting article. I have been playing around with the idea of buying deep in the money longer range SPY when the market is up and volatility lower, and then selling shorter dated lower puts against them when the market is down and volatility is higher.


    As the market rebounds up again and volatility slumps, the short puts can be bought back at a profit.


    Worst case scenarios are


    1. That SPY plunges way below the short puts, in which case you don´t actually lose anything except potential profit, since the long puts will always gain too. Also you can roll the short puts.


    2. SPY goes on an upward tear (but unlikely to gap up 100 points over a weekend) in which case you cash in the short puts and the long puts lose value. However, since the the long SPY puts are, of course, a hedge against a falling market, any losses on the SPY puts should be more than offset by gains elsewhere in the portfolio.


    Not win-win, but not lose-lose either.


    The key is clearly to have a range of short and long positions with different calendarity in a portfolio, and to take money off the table when any short term position is substantially in the money and releverage.
    12 Aug 2011, 04:48 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Rookie,


    I was holding some SPY Dec 2012 140.0 puts when the sell-off started, I cashed them in, sold the last one when SPY hit 112.5. But I could have gotten some very nice premium selling puts against the position.


    I've used the strategy you describe a few times, on CRM, I made money three times out of three, never too much because of the short put, but it did make it possible to trade against CRM without too much risk too the upside.


    I think your idea is workable, I know I've become very comfortable doing it the other direction with calls.
    12 Aug 2011, 05:42 PM Reply Like
  • Rookie IRA Investor
    , contributor
    Comments (2881) | Send Message


    Great minds think alike. I also had some SPY December 140 puts that did very well for me, but I liked them so much that I rolled them into October 126 puts so that there were more of them. Also I figured the fun and games would probably be over by the end of October.


    Regarding selling short calls against LEAPS, I have been doing the same thing with AAPL. The difference with doing it with puts is that you can sell the short put when the volatility is high, whereas when you sell the calls, you are probably going to have to do it when volatility is low.


    For example, with AAPL you typically want to sell the calls just after the underlying has run up going into earnings when you are looking for a pullback. When the pullback comes, and your short call falls in value, the volatility premium works against you.


    With the puts the volatility runs in your favor. Sell when volatility is high and buy back when it wanes.
    12 Aug 2011, 05:55 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » The way I've been doing it, I usually buy the LEAPS and at the same time I sell out of the money calls with a shorter duration, but with the same or greater time value.


    That leaves me with time on my side. I've tried waiting for the stock to go up before selling the calls, and that's nice when it works.


    This type strategy worked well in 2009 and 2010, there's a lot of money to be made in an up market. I still think the maket ends 2011 quite a bit higher than it started, but that doesn't look as good today as it did a month ago.
    12 Aug 2011, 06:59 PM Reply Like
  • Rookie IRA Investor
    , contributor
    Comments (2881) | Send Message
    Ah, yes, if you can tell me where the market ends on New Year´s Eve, I will give you the perfect options strategy.
    12 Aug 2011, 07:07 PM Reply Like
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