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Brent Leonard
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www.brentleonard.com Retired options and stockbroker, ROP, RIA Retired Adjunct Professor of Finance at Golden Gate Univ. Editor, TSAASF Review Private Investor Author: Zero (IN)Tolerance, blogs: http://ditmcalls.blogspot.com http://www.mktsentiment.blogspot.com... More
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Zero (IN)Tolerance
  • BEATING THE MARKET 0 comments
    Nov 30, 2012 9:26 AM

    As another year comes to a close, it is prudent to reassess one's fiscal condition, and consider future adjustments to their investments. Previous columns have delineated an investment strategy - one that is by definition defensive, conservative, and yet, optimal when comparing it to other strategies currently in use. Noting anecdotal reports of not only mutual funds barely breaking even, but also the average hedge fund only slightly on the plus side, this strategy consistently over time should outperform most others, as well as providing a partial safety net in case of another Flash Crash.

    Having extensively tested this strategy over nearly four years in several brokerage accounts, with the purest microcosm in a small five-figure IRA (no contributions or withdrawals allowed) which is actually currently making new highs despite a choppy market, it has been found to require little monitoring time or activity. Time-wise, it is somewhere between less effectual day-trading and obsolete buy-and-hold (NASDAQ:FOLD).

    So what is this strategy, you ask? Nicknamed DITM, for deep-in-the-money covered call writing, it is a seldom used variation on the normal covered call plan, but "pre-sells" the stock 5-6 months out at a 5 to 10% lower price (providing the safety net of someone else's money) to move around in its sinusoidal motion until expiry. Screening for a stock or ETF with at least a 3% dividend that also has enough "extrinsic" option value, if called prematurely, one is less pressured to get whipsawed out of the stock- usually at the low. Even if the stock (and/or the overall market) drops precipitously, as has happened over the past 4 years at least a dozen times, one is consoled with the fact that it they are receiving yet a higher dividend percent - even if the stock temporarily goes below the pre-sold price- and that they are also milking the call option premium each day (theta).

    Consider this hypothetical example: Stock XYZ is currently at $50 a share;

    it goes ex-dividend on December 2 with a quarterly dividend of $.50 per share.. One buys 100 shares on November 30 to get the nearby dividend;

    simultaneously, they sell a covered call (a Buy/Write) - the June $45 strike price- for $6. $5 makes up for the loss from 50 to 45, where XYZ should be called away; the $1 is extrinsic call time premium. $2 per year in dividends would be 4%; based on a $45 stock price, the dividend rate is now 4.44% instead. Counting on two dividends ($1), plus the $1 from the call, total return for 6 months would be 4.44%; annualized (done twice in 12 months) the return becomes 8.89%. Note: if the stock remains at 50, one can merely roll out the June call to December, keeping the stock.

    With nearly thirty years experience as a professional senior options trader for a major firm, as well as money manager and individual investor, this columnist has see about every type of market. After the mother of all Bull markets from the 1980s, an extended period of consolidation, compounded by the Fed's current protracted zero rate policy, is ideal for this strategy. Admittedly there have been a handful of plungers, such as British Petroleum (NYSE:BP), Cliff Resources (NYSE:CLF), et.al., but these are equally offset with stocks that are prematurely called away early - 1 or 2 months before option expiry - which compresses the holding time, making an annualized return (as if done multiple times in 12 months) 30-40%.

    The only flaw in this plan is in a case of another Black Swan which does not recover for a long time. Studies by both University of Chicago and Standard and Poor's show at least one, but no more than two Bear markets per decade since 1900. The previous decade had two, and although both were around an uncharacteristically deep 50% drop, they were both V-Spikes, recovering quickly behind their electronic drivers. Unlike a "collar" strategy, where a covered call produces the funds for a protective put, but lowers the return if not needed, DITM does need to be hedged. With the safety net, some warning is given, and even if a loss is incurred, it is much less than with an Index fund or unhedged portfolio.

    Despite writing a book on DITM - Zero (NYSE:IN)Tolerance from Amazon- and giving several talks in the San Francisco Bay Area, it has few adherents that consistently follow it. Ideal for retirees and prudent investors searching for alternatives to punitive interest rates without the higher risk, it is prudent for at least a portion of one's assets. There is also a blog: http://ditmcalls.blogspot.com which can be researched, with Older Posts showing actual trading results over several time frames, all returning high single-digit results.

    More information on DITM is also available at this columnists website:

    http://brentleonard.com

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: The concept of this article was accepted previously by SA - it is also published under the populist Examiner.com site with minimal viewers

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