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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
  • Leaping Ahead 0 comments
    Feb 7, 2014 3:50 PM

    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

           
                         
           
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