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Leaping Ahead

Leaping Ahead

Recently Stephen Todd pointed out that since 1900 there have only been three times that the stock market has risen five consecutive years up until now: the '20s, '40s, and '80s, which did not end well! A fourth time it rose 9 years - 1990s (say no more). For this reason it seems logical to assume a sideways to down market-strategy would be prudent. I also thought this in May 2009, when I started testing my DITM (deep-in-the-money covered call) hedging strategy, which happened to coincide with the recent 4th five-year up market, although my test account actually rose 11% per year for 4 years, then flatlined due to poor/early sector selection and low option Volatility caused by the Up market. It also increased the cushion from being 5 to 10% in the money protection, to much higher, for which I am now thankful.

With a higher likelihood of stocks now moving sideways to down for the near future, an even more prudent strategy is being tested - one that a client successfully employed several years ago when I was a senior option trader (NYSE:ROP) with Charles Schwab. This client would turn the tables, so to speak, from being the "patsy" in the game to being the House, or casino - by selling options rather than speculating on potential direction. The concept is to buy a quality stock in the $5 to 20 range that has LEAP options and sell a covered call (never a "naked" one), and simultaneously selling the same year Leap put- both slightly out of the money.

Normally one can immediately bring between 1/3 and 1/2 of the funds spent on buying the stock, providing a better cushion than the above DITM plan; although being similar to it, the Safety and Reward are both considerably higher, and the monitoring is almost negligible for about two years- at which time the options expire. Although potential annual double-digit profits are likely, direction is not important, but being called away at expiry does increase the return.

Since one year ago I have amassed a Leap portfolio of 20 positions, mostly done recently.

As with any investing strategy there are Risks attached:

Below is the logic of the strategy with a theoretical example, and the "Visible Hand" of five fingers ( A through E) of what can happen over time.

As with "E", more stock can be put to the investor - so they must want to own the stock.

 

**Worst case:

Stock gets taken over or involved in merger - adjusted options

 
     

gets complicated, but no loss involved; XYZ goes bankrupt: 1 in 1,000

 
     

Profits on other 15-20 stocks make up for loss.

     
 

***commissions not included; stocks bought in IRAs, etc. must sequester Max Loss(e.g.$700)

     

In IRAs, profits become 8%: and 11% annualized (if called away)

 
     

If repeated every two years, no stock cost - profits much higher.

 
 

A Strangle is just a Straddle with different prices for calls and puts

     
     

THEORETICAL

LEAP

STRANGLE

       
                     
 

STOCK:

XYZ

$9

       

DEBIT

CREDIT

 
 

Buy 100 shares of XYZ at $9.00

     

$900

   
 

Sell 1 LEAP covered call -

Jan.2016 10-strike price @ $1.20

 

120

 
 

Sell 1 LEAP put-Jan. 2016 7-strike price @ $.80

     

80

 
 

4% Dividend; 9 quarters @ $9/Q=

       

81

 
             

TOTALS:

900

281

 
 

% Profit:

31.22%

               

RESULTS

Ann.%:

14.40%

(over 12 months, not 26)

           

A

HomeRun:

If stock called away at $10 in Jan.2016

$281+100=381

   
 

% Profit:

42.33%

               
 

Ann.%:

19.54%

               

B

Stock settles at $10 on expiry-

Maximum profit, repeat NEXT two years

raise option strike prices.

               

call:11

put-:9

 

C

Stock stays the same: $9

Maximum profit, repeat for two years

     
 

* If stock falls to $7 ON Jan.21, 2016 - Keep $281, resell 2 more years out (loss of $200 on XYZ).

D

BUT-

Sell $6 put; sell $8 call (2018)

No cost for stock this time!!

     
                     

E

*Worse Case: Stock falls BELOW $7 put strike price ON Jan.21 2016:

     
   

100 shares of XYZ are "put" to you; repeat D