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Leverage: Live by the Sword, Die by the Sword?

|Includes:AGO, HIG, MetLife, Inc. (MET), PRU, 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