Eliminating Dogs- Introduction

Eliminating Dogs


Introduction

So far, I have considered the effect of selling at-the-money puts on the entire universe of 217 stocks that had LEAPS on March 31, 1997. You saw that 77.7 percent of the time, the stock closed out of the money, and for every $8,354 received in premiums and interest on expired LEAPS, the net amount retained was $3,559. The remaining portion of the premiums and interest, $5,620, was needed to close out losing positions. Because of the longer expiration time involved, the net amount retained on the far-term LEAPS averaged out to 48.1 percent, while on the near-term LEAPS the net amount retained averaged out to just 36 percent. 

Finally, the account balance at the end of the ten-year period was 44.3 percent of the total premiums ever collected. Such results are hardly worth boasting about. One way to improve them might be to restrict the sale of LEAP puts to better-quality issues. I'll investigate what would have happened if I had sold LEAP puts only on those issues whose underlying stocks were rated 2 or better by First Call or were rated B or better by Standard & Poor's. We use or rather than and because the 37 stocks appearing that were not rated by Standard & Poor's would automatically have been eliminated on that account alone. I will conduct this investigation in three phases.

In the first phase, the universe will consist of those issues whose underlying stocks were rated 2 or better by First Call or were rated B or better by Standard & Poor's. In the second phase, the universe will be restricted even further to those issues whose underlying stocks were rated 1.6 or better by First Call or B+ or better by Standard & Poor's. And in the third phase, the universe will be restricted to those issues whose underlying stocks were rated 1.2 or better by First Call or A- or better by Standard & Poor's. For lack of better nomenclature, we will refer to these populations as the "B minimum," "B+ minimum," and "A- minimum" universes.

The B Minimum Universe

The method was first applied to those LEAPS whose underlying stocks were rated 2 or better by First Call or B or better by Standard & Poor's. To be precise, the above criteria ought to be applied on a month-by-month basis to each stock over the ten-year history studied. But because there is no readily available history file of First Call ratings, what was done instead was to include or exclude issues on the basis of their First Call and S&P ratings of March 31, 1997. On that basis, LEAP puts would have been sold on 178 of the 217 stocks. As is discussed below, the elimination of the lowest-rated 39 issues substantially improved the results. The number of LEAP contracts written over the ten-year simulation decreases to 38,637. 

Of these, 33,312 expired and 5,325 were still active on the cutoff date of March 31, 1997. The percentage of options expiring out of the money is now 80 percent. Although this represents an increase of just 2.4 percentage points in the OTM rate from the base level of 77.7 percent in Run No. 1, the impact on overall retention rates is significant. Shows that the overall retention rate grows from 42.6 percent in Run No. 1 to 54.3 percent, an increase of 11.7 percentage points. This premium retention rate is now 46.6 percent on the near-term LEAPS and 60.9 percent on the far-term LEAPS. We see that the account value on March 31, 1997, resulting from the net premiums, accrued interest, and unrealized gains will be $5,117,983. This figure is 57.5 percent of the $8,895,368 in premiums ever generated.

The B+ Minimum Universe

Suppose I had discriminated even further and restricted the sale of LEAP puts to stocks that had a First Call rating of 1.6 or better or an S&P rating of B+ or better on March 31, 1997. The number of issues qualifying would now be just 115, with dramatically improved results. The number of LEAP contracts written decreases to 25,302, with 21,858 having expired and 3,444 still active on March 31, 1997. The percentage of options expiring out of the money would have increased even further to 84 percent. 

Shows that the overall retention rate is now 66.2 percent, an increase of 23.6 percentage points from the baseline level of 42.6 percent in Run No. 1. The premium retention rate is now 57.8 percent on the near-term LEAPS and 73.4 percent on the far term LEAPS. We see that the account value on March 31, 1997, resulting from the net premiums, accrued interest, and unrealized gains will be $3,697,495. This figure is 69.7 percent of the $5,303,771 in premiums ever generated.

The A- Minimum Universe

Now suppose I further restricted the sale of LEAP puts to stocks that had a First Call rating of 1.2 or better or an S&P rating of A- or better on March 31, 1997. The number of issues qualifying would have fallen to just 50, representing the highest-quality issues having LEAP options. The number of LEAP contracts written decreases to 11,520, with 10,018 having expired and 1,502 still active on March 31, 1997. The percentage of options expiring out of the money would have increased further still to 87.1 percent.

Shows that the overall retention rate is now 79.9 percent, an increase of 37.3 percentage points from the base level of 42.6 percent in Run No. 1. The premium retention rate is now 71.8 percent on the near-term LEAPS and 86.8 percent on the far term LEAPS. We see that account value on March 31, 1997, resulting from the net premiums, accrued interest, and unrealized gains will be $1,611,512. This figure is 84.9 percent of the $1,898,748 in premiums ever generated.

RUN NUMBER 2

ATM Strike Price Is the High, Low, or Closing Stock Price:         C
No. of Steps LEAP Put Is below ATM Strike Price:                        0
Minimum No. of Months till Expiration:                                          8
Premium Reinvestment Rate:                                                             6.0%
Minimum First Call Rating:                                                                 2.0
Minimum Standard & Poor's Rating:                                                B
No. of Stocks Meeting Either Criterion:                                            178

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 3

ATM Strike Price Is the High, Low, or Closing Stock Price:         C
No. of Steps LEAP Put Is below ATM Strike Price:                         0
Minimum No. of Months till Expiration:                                          8
Premium Reinvestment Rate:                                                             6.0%
Minimum First Call Rating:                                                                 1.6
Minimum Standard & Poor's Rating:                                                B+
No. of Stocks Meeting Either Criterion:                                            115

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 4

ATM Strike Price Is the High, Low, or Closing Stock Price:          C
No. of Steps LEAP Put Is below ATM Strike Price:                          0
Minimum No. of Months till Expiration:                                           8
Premium Reinvestment Rate:                                                              6.0%
Minimum First Call Rating:                                                                  1.2
Minimum 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


Summary of Results

As a way of comparing the results obtained so far, let's tabulate the OTM rates, retention rates, and overall ten-year value ratios for the four cases investigated.

Table  Figures of Merit as a Function of Stock Rating


As Table clearly shows, as the quality of the underlying stocks increases, the greater the chance that the options will expire out of the money, the greater the percentage of premiums retained, and the greater the account balance as a percentage of premiums collected.

I do not mean to imply that investors should limit the sale of LEAP puts strictly to high-quality companies rated B+ or better. Situations will arise from time to time where it is financially advantageous to sell options on companies with lesser-quality issues, especially in those instances involving reorganizations, turnarounds, takeovers, and mergers.

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