Advanced Strategies- Introduction

Advanced Strategies


Introduction

The strategies thus far investigated barely begin to cover the many ways to acquire stock using the premiums received from the sale of LEAP puts. One method that I especially like is to divide the potential universe of higher-rated issues having LEAPs into three categories: (1) stocks that I favor highly, currently hold in portfolio, and want to acquire more of; (2) stocks that I would like to acquire for my portfolio at below-market prices; and (3) stocks that I am more or less neutral about, but would not mind acquiring for my portfolio at prices substantially below today's market prices. In keeping with this "triage" approach, I sell into-the-money LEAP puts on stocks in the first category, at-the-money LEAP puts on the second category, and out-of-the-money puts on the third category. I use the term into-the-money rather than in-the-money to signify the use of exercise prices not more than one or at most two strikes above the current market price.

As a variation on this theme, you could take the 50 or so stocks classified as A- or better and sell into-the-money LEAP puts on the ones rated A+, at-the-money puts on the ones rated A, and out-of-the-money puts on the ones rated A-. Once you acquire proficiency and experience, you could start including B+ rated stocks in this last group as well. There are so many variations possible on this strategy that as a practical matter I decided to limit the analysis to just two variatio. The first method considered is to restrict the sale of LEAP puts to far-term LEAPS and not deal with near-term LEAPS at all. The second method is a mix-and-match approach, in which puts are simultaneously sold on both higher-quality, far-term LEAPS and broader-quality, near-term LEAPS.

Far-Term LEAPS Alone Strategy

The computer simulations conducted thus far have clearly demonstrated that far-term LEAPS are consistently more profitable and safer than near-term LEAPS. The reasons for this include the fact that standard option-pricing formulas do not take into account the long-term growth rates of the underlying issue and the quite reasonable assumption that over the long term, stock prices of better-quality issues move inexorably upwards. The effect of restricting the sale of puts to far-term LEAPS can be seen by extracting the relevant line items from the 20 computer simulations already performed. The combined rollover and acquisition strategy is the equivalent of selling two far-term LEAPS on each issue every month. 

Should any such pair of LEAP puts appear to be winding up in the money as expiration approaches, one of them is rolled out while the other is used to acquire stock as a result of exercise and assignment. When this strategy is employed, the summary chart for far-term LEAPS appears. Comparing the results for the far-term LEAPS alone in Table 11.1 with those for the mixed near-term/far-term LEAPS shows the improvement in the steady-state out-of-the-money and retention rates obtainable. Although the account value ratios are roughly the same, in terms of absolute dollars the ten-year account values for the far-term LEAPS alone are much larger because the base of premiums collected to which those percentages are applied is so much larger. 

Table  Figure of Merit Comparisons


Mix-and-Match Strategies

Another strategy is to sell far-term LEAP puts on the higher-quality, A- minimum universe of 50 stocks while at the same time selling near-term LEAP puts on the broader-quality B+ minimum universe of 115 stocks. The near-term B+ LEAP puts would be rolled over if they wind up in the money as expiration approaches, while the far-term A-LEAP puts would be used for stock acquisition. Because of the higher financial exposure and potential risk of assignment of the near-term B+ LEAPS, the strike prices selected for them will be one step below the level selected for the far-term A-LEAP puts. Two such mix-and-match combinations have been selected to illustrate the approach, ranging from the most conservative to the most aggressive.

Conservative Mix-and-Match Strategy

Run No. 21 shows the results of selling far-term LEAPS that are one step out of the money on the A- minimum universe of 50 stocks while simultaneously selling near-term LEAPS that are two steps out of the money on the B+ minimum universe of 115 stocks. The results shown are stronger than those obtained in Run No. 18, for which the far-term LEAP universe was also the A- minimum universe of 50 stocks. In particular, collecting premiums from the larger universe of 115 near-term LEAPS has the net effect of lowering overall risk with only a moderate reduction of overall benefits. Although the account value is 122.3 percent of the total premiums collected—down from the 144.7 percent figure seen in Run No. 18—it is applied to a larger base. The list of acquired stocks for this mix-and-match strategy is the same as the one for Run No. 18.

Moderate Mix-and-Match Strategy

Run No. 22 shows the results of selling far-term LEAPS that are at the money on the A- minimum universe of 50 stocks while simultaneously selling near-term LEAPS that are one step out of the money on the B+ minimum universe of 115 stocks. The results shown are stronger than those obtained in Run No. 16, for which the far-term LEAP universe was also the A- minimum universe of 50 stocks. In particular, collecting premiums from the larger universe of 115 near-term LEAPS has the net effect of lowering overall risk, again with only a moderate reduction of overall benefits. And as with the conservative strategy, although the account value is 135 percent of the total premiums collected—down from the 154.2 percent figure seen in Run No. 16—it is applied to a larger base. The list of acquired stocks for this mix-and-match strategy is the same as the one for Run No. 16.

RUN NUMBER 21

ATM Strike Price Is the High, Low, or Closing Stock Price:                             C
No. of Steps Near-Term LEAP Put Is below ATM Strike Price:                       2
No. of Steps Far-Term LEAP Put Is below ATM Strike Price:                          1
Minimum No. of Months till Expiration:                                                              8
ITM Near-Term LEAPS Are Rolled Over:                                                             Y
Stocks of ITM Far-Term LEAPS Are Purchased:                                                 Y
Premium Reinvestment Rate:                                                                                  6.0%
Minimum Near-Term First Call Rating:                                                                 1.6
Minimum Near-Term Standard & Poor's Rating:                                                B+
No. of Stocks Meeting Either Criterion:                                                                 115
Minimum Far-Term First Call Rating:                                                                   1.2
Minimum Far-Term Standard & Poor's Rating:                                                   A-
No. of Stocks Meeting Either Criterion:                                                                 50

Table  LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS


Table  Premiums Collected and Account Values


RUN NUMBER 22

ATM Strike Price Is the High, Low, or Closing Stock Price:                              C
No. of Steps Near-Term LEAP Put Is below ATM Strike Price:                        1
No. of Steps Far-Term LEAP Put Is below ATM Strike Price:                           0
Minimum No. of Months till Expiration:                                                               8
ITM Near-Term LEAPS Are Rolled Over:                                                              Y
Stocks of ITM Far-Term LEAPS Are Purchased:                                                  Y
Premium Reinvestment Rate:                                                                                   6.0%
Minimum Near-Term First Call Rating:                                                                  1.6
Minimum Near-Term Standard & Poor's Rating:                                                 B+
No. of Stocks Meeting Either Criterion:                                                                  115
Minimum Far-Term First Call Rating:                                                                    1.2
Minimum Far-Term Standard & Poor's Rating:                                                    A-
No. of Stocks Meeting Either Criterion:                                                                  50

Table  LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS


Table  Premiums Collected and Account Values


A Word of Caution

With enough time and experience, some investors may feel inclined to take on higher levels of risk by selling far-term LEAP puts that are deeply into the money and/or near-term LEAP puts that are at the money. Fight the urge to do so, for adopting too aggressive an approach can leave you especially vulnerable to a sudden downturn in the market.

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