We have consistently stated that as the market rallies higher, we will continually look for defensive-type stocks. Price is now almost 3 years from the December lows which means that the 4-year cycle low may come due next year. If our research is correct, we expect a failed yearly cycle probably sometime next year or in early 2020 which will result in price most likely dropping below the recent October lows before resuming the bull market.
Where the market will eventually bottom, it is anyone's guess. Now a lot of traders/investors are not going to agree with this. The recent volatility we have had in stocks really brought the bears out in force. There is one way though investors do not have to play this so-called guessing game. This is by having a non-correlated portfolio of stocks/asset classes. The non-correlation ensures that if one stock or asset class is under-performing, its performance will not adversely affect the other positions.
For example, other asset classes which have a low correlation to US equities would be gold and bonds, etc. Emerging markets for example have a rather high correlation with US equities so that asset classes wouldn't act as true diversification. What do you do though when you do not have the capital to set up a truly diversified portfolio? This is where the deep in the money call option [with years to expiration (LEAP)] really comes into its own.
95% of the time, we are option sellers as we believe there are far more advantages to this strategy. However, on rare occasions, we do recommend buying deep in the money call options when the situations permits. Let's go through setting up a deep in the money option in the SPDR Gold Shares (GLD), why would we do it, and advantages of the same.
The main reason why we would use this strategy is because of the lower up-front capital required in order to achieve the same returns. For example, GLD closed yesterday (Tuesday 4th of December) at just over $117 a share. Buying 100 shares of this ETF at the close yesterday would have cost around $11,700. This position essentially gives you 100 deltas in that the ETF should move basically on par with changes in the spot gold price.
However, if we look at GLD's option chain below, we can see that we can buy the $85 strike price which expires in January 2021 for just over $37.50. Now since one option contract controls 100 shares, one $85 call option would cost us $3,750. Here are the advantages of this strategy.
Source: Interactive Brokers.com
- The LEAP will move on par with GLD. As the chart illustrates above, the delta of the call option is over 95. This basically means the option will move on par with the ETF. Remember we put up just $3750 whereas owners of the ETF had to fork out $11,700 for 100 shares. Furthermore, if gold was to rally from this point, the delta of the $85 call would keep on increasing as it would go deeper in the money.
- The downside risk is obviously less. The maximum one can lose is the amount they pay on the call option. On the other hand, the break-even on the investment is the cost of the LEAP + the strike price which is ($37.58+$85) = $122.58. The price of GLD would have to make it by this price by expiration for the investment to show a profit. This $122.58 break-even price though would only be the break-even price at expiration as there would be no more extrinsic value in the option. Before that, the break-even would be lower depending on how much time there would be in the option. This is what the trader has to give up for being able to control 100 shares for a fraction of the cost of a full ETF investment.
- Higher return on Investment. This is key as it gives the trader more leverage and enables more diversification in the portfolio if funds are slim. The almost $8k saved here could be used to adopt the same strategy in other underlyings or deploy that saved capital in income-derived investments such as bonds or low beta dividend growth stocks.
Obviously, this strategy will have it detractors because we are purchasing an option meaning that the decay of an option’s extrinsic value or "theta" will be negative. Buying "time" means we are racing against the clock to some degree. In saying this, we only use this strategy in call options which are 2 to 3 years away from expiring. Furthermore, to echo Paul Tudor Jones sentiments,
If a position goes against us, we get right out because we know at any time, we can get back in
Jones just doesn't use this pretense in options but also in stocks mainly through stop-losses. When trading call options, this statement makes a whole lot of sense. It is always better to liquidate and then wait or roll (if there are further expirations available) when trading "time." Instead of stop-losses, many traders who utilize this strategy use "time" losses especially if the position is not trending in the desired direction. The worst trait one could have when utilizing this strategy is stubbornness. By honoring one's time and/or stop losses, I see no problem with using this strategy.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.