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Leaping Ahead

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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 (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.

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

Theoretical Leap Strangle .......... DEBIT CREDIT
Stock: XYZ $9
Buy 100 shares at $9 ..............$900
Sell 1 Leap covered call
Jan.2016 10-strike @1.20 ...................$120
Sell 1 Leap naked put
Jan.2016 8-strike @$.80 .....................$80
4% dividend; 9 quarters .......................$81
TOTALS: 900 281
%Profit 31.22%
Annualized 14.4%
"Visible Hand" Scenario
A: Stock called away in 2016: $281 + $100 apprec.=381
B: Stock settles at $10 at expiry: Max. profit, repeat to 2018
C: Stock stays at $9: Keep 281, repeat to 2018
D: Stock falls to $7: Keep put and call premium, paper loss of $2,
so lower Strangle to $6 and $8, respectively
E: Worst Case: Stock drops below $7 - more stock put to you, or exit.



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