Roll 'Em Out
Introduction
The previous demonstrated that by writing LEAP puts on higher-quality issues one or two steps below the at-the-money market price, it is possible to increase the rate at which the options expire out of the money to levels ranging from 92 percent to 97 percent. An impressive result, to be sure, but more impressive results can be achieved by rolling out any LEAP puts that appear to be winding up in the money as expiration approaches. This entails a two-step process of (1) buying back the LEAP puts shortly before the expiration date (thus closing out those positions), and (2) writing an equivalent number of LEAP puts with expiration dates either one or two years away.
You saw that there are numerous ways to carry out this type of mitigation strategy. Besides selecting the expiration date, you can also choose an appropriate strike price. Suppose an at-the-money LEAP put had been sold on a stock with a volatility of 0.40 and the price was $100 a share with 25 months to expiration. From Table, you see that the (European-style) option premium is very close to $1,600 per contract. Now suppose that some two years later the stock is, unfortunately, down to $90. To close out the position, you buy back the option for close to its intrinsic value* of $1,000, a strategy that by itself would ensure an overall profit of $600 per contract, even after commissions.
What happens next is that you roll out the option. Because the month is January (that's when all LEAPS expire), there will be two replacement LEAPS available: the near-term LEAP put expiring the following January and the far-term LEAP put expiring the January two years away. There will, of course, be a range of strike prices available to you—S95, $90, $85, and so on; most likely, the original $100 price will be available and perhaps an $80 strike as well. With two expiration dates (near and far) and, say, five strike prices at or near the money, there are as many as ten viable alternatives open to you.
Which of these to select will depend on how long you feel will be required before the company resumes its earnings growth, regains market share lost, or otherwise recovers its former price levels. The more rapid and certain the recovery, the higher the strike price and shorter the term you can afford to select. The weaker the prospects of recovery, the lower the strike price and longer the term you should select. If the company has really faltered, your best course of action may well be to limit further financial exposure and not perform the second leg of the procedure.
Procedure
To investigate the extent to which the use of rollovers can mitigate financial exposure and thereby enhance overall performance, the following two assumptions were made in all instances where a LEAP put wound up in the money as expiration approached: (1) the in-the-money LEAP put was purchased for its intrinsic value, and (2) a single LEAP put was then sold at a strike price and expiration date that reflected the same philosophy as that governing the original LEAP put.
That is, if the original LEAP put was a near-term one, the replacement LEAP put sold was also near-term; if the original LEAP put was a far-term one, the replacement LEAP put sold was also far-term. Similarly, if the original LEAP put was out of the money, at the money, or in the money at the time it was sold, a correspondingly conservative, neutral, or aggressive stance was adopted for the replacement LEAP put sold. That is, LEAP puts originally one step out of the money were replaced by one-step out-of-the-money puts.
These strike prices are relative to the stock price at the time, so in the example cited previously, the at-the-money LEAP put of $100 would be replaced by an at-the-money $90 LEAP put with an expiration date two years away. With this approach in mind, six computer simulations were conducted in order to determine the impact of rollovers on the bottom line. These simulations were run for the at-the-money LEAPS, one-step out-of-the-money LEAPS, and two-step out-of-the-money LEAPS, in each case for both the B+ minimum and A- minimum stock universes.
That is, if the original LEAP put was a near-term one, the replacement LEAP put sold was also near-term; if the original LEAP put was a far-term one, the replacement LEAP put sold was also far-term. Similarly, if the original LEAP put was out of the money, at the money, or in the money at the time it was sold, a correspondingly conservative, neutral, or aggressive stance was adopted for the replacement LEAP put sold. That is, LEAP puts originally one step out of the money were replaced by one-step out-of-the-money puts.
These strike prices are relative to the stock price at the time, so in the example cited previously, the at-the-money LEAP put of $100 would be replaced by an at-the-money $90 LEAP put with an expiration date two years away. With this approach in mind, six computer simulations were conducted in order to determine the impact of rollovers on the bottom line. These simulations were run for the at-the-money LEAPS, one-step out-of-the-money LEAPS, and two-step out-of-the-money LEAPS, in each case for both the B+ minimum and A- minimum stock universes.
Rolling At-the-Money LEAPS
Run No. 9 is the analog of Run No. 3 and shows the effect of adopting a rollover strategy for any issues winding up in the money from among the 115 stocks in the B+ minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 25,302 to 29,292. The net effect of rollovers is to reduce the ITM exposure of $3,174,423 in Run No. 3 to $1,249,983. As a result, the retention rate on the premiums received from the sale of the expired LEAP contracts increases from 66.2 percent in Run No. 3 to the 78.5 percent.
From Table you see that the account value on March 31, 1997, will have grown to $4,360,099. This sum is 80.3 percent of the total premiums collected over the ten-year period and is significantly higher than the 69.7 percent without rollovers seen in Run No. 3.Run No. 10 is the analog of Run No. 4 and shows the effect of adopting a rollover strategy for any stocks winding up in the money from among the 50 issues in the A-minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 11,520 to 12,932.
From Table you see that the account value on March 31, 1997, will have grown to $4,360,099. This sum is 80.3 percent of the total premiums collected over the ten-year period and is significantly higher than the 69.7 percent without rollovers seen in Run No. 3.Run No. 10 is the analog of Run No. 4 and shows the effect of adopting a rollover strategy for any stocks winding up in the money from among the 50 issues in the A-minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 11,520 to 12,932.
The net effect of rollovers is to reduce the ITM exposure of $431,447 in Run No. 4 to $247,180. As a result, the retention rate on the premiums received from the sale of the expired LEAP contracts increases from 79.9 percent in Run No. 4 to 92.7 percent. From Table, we see that the account value on March 31, 1997, will have grown to $1,849,570. This sum is 95.9 percent of the total premiums collected over the ten-year period and is significantly higher than the 84.9 percent without rollovers seen in Run No. 4.
Rolling One-Step Out-of-the-Money LEAPS
Run No. 11 is the analog of Run No. 5 and shows the effect of adopting a rollover strategy for any stocks winding up in the money from among the 115 issues in the B+ minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 25,302 to 27,074. Yet again, the net effect of rollovers is to reduce the ITM exposure of $822,478 in Run No. 5 to $686,414. The retention rate on the premiums received from the sale of the expired LEAP contracts increases from 70.4 percent in Run No. 5 to 76.9 percent. From Table, you see that the account value on March 31, 1997, will have grown to $2,284,359.
This sum is 77.9 percent of the total premiums collected over the ten-year period and is significantly higher than the 72.6 percent without rollovers seen in Run No. 5. Run No. 12 is the analog of Run No. 6 and shows the effect of adopting a rollover strategy for any stocks winding up in the money from among the 50 issues in the A-minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 11,520 to 12,010. The net effect of rollovers is to reduce the ITM exposure of $131,940 in Run No. 6 to $91,637.
The retention rate on the premiums received from the sale of the expired LEAP contracts increases from 90 percent to 96.2 percent, and from you see that the account value on March 31, 1997, will have grown to $891,361. This is 96.8 percent of the total premiums collected over the ten-year period and is significantly higher than the 91.6 percent without rollovers seen in Run No. 6. Note that the retention rate for the far-term LEAPS is 101.8 percent. Retention rates greater than 100 percent can be achieved as a result of the interest earned between the sale of options and their corresponding expiration dates.
This sum is 77.9 percent of the total premiums collected over the ten-year period and is significantly higher than the 72.6 percent without rollovers seen in Run No. 5. Run No. 12 is the analog of Run No. 6 and shows the effect of adopting a rollover strategy for any stocks winding up in the money from among the 50 issues in the A-minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 11,520 to 12,010. The net effect of rollovers is to reduce the ITM exposure of $131,940 in Run No. 6 to $91,637.
The retention rate on the premiums received from the sale of the expired LEAP contracts increases from 90 percent to 96.2 percent, and from you see that the account value on March 31, 1997, will have grown to $891,361. This is 96.8 percent of the total premiums collected over the ten-year period and is significantly higher than the 91.6 percent without rollovers seen in Run No. 6. Note that the retention rate for the far-term LEAPS is 101.8 percent. Retention rates greater than 100 percent can be achieved as a result of the interest earned between the sale of options and their corresponding expiration dates.
Rolling Two-Step Out-of-the-Money LEASPS
Run No. 13 is the analog of Run No. 7 and shows the effect of adopting a rollover strategy for the 115 issues in the B+ minimum universe. As a result of rollovers, the total number of LEAP contracts written increases from 25,302 to 26,306. The rollovers reduce the ITM exposure from $446,329 in Run No. 7 to $390,194. The retention rate on the premiums received increases from 71.1 percent to 76.1 percent. From you see that the account value on March 31, 1997, will have grown to $1,281,850, which is 77.5 percent of the total premiums collected over the ten-year period and which is significantly higher than the 73.6 percent without rollovers seen in Run No. 7.
Run No. 14 is the analog of Run No. 8 and shows the effect of adopting a rollover strategy for any stocks winding up in the money for the 50 issues in the A- minimum universe. As a result of rollovers, the total number of LEAP contracts written goes from 11,520 to 11,815. The rollovers reduce the ITM exposure from $48,846 in Run No. 8 to $32,351, and the retention rate on the premiums received increases from 95.7 percent to 100.7 percent. From you see that the account value on March 31, 1997, will have grown to $490,331, which is 103.2 percent of the total premiums collected over the ten-year period and is higher than the 98.3 percent without rollovers seen in Run No. 8. As you saw in Run No. 12, retention rates greater than 100 percent can be achieved as a result of the interest earned between the sale of options and their corresponding expiration dates.
RUN NUMBER 9
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
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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 10
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
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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 11
ATM Strike Price Is the High, Low, or Closing Stock Price: C
No. of Steps LEAP Put Is below ATM Strike Price: 1
Minimum No. of Months till Expiration: 8
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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 12
ATM Strike Price Is the High, Low, or Closing Stock Price: C
No. of Steps LEAP Put Is below ATM Strike Price: 1
Minimum No. of Months till Expiration: 8
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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 13
ATM Strike Price Is the High, Low, or Closing Stock Price: C
No. of Steps LEAP Put Is below ATM Strike Price: 2
Minimum No. of Months till Expiration: 8
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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 14
ATM Strike Price Is the High, Low, or Closing Stock Price: C
No. of Steps LEAP Put Is below ATM Strike Price: 2
Minimum No. of Months till Expiration: 8
ITM Near-Term LEAPS Are Rolled Over: Y
ITM Far-Term LEAPS Are Rolled Over: Y
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 Rollout 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
To compare the results obtained, I will again tabulate the OTM rate, the retention rate, and the overall ten-year value ratio for all runs done so far.
Table Figure of Merit Comparisons
As you can readily, adopting a rollover strategy to mitigate potential financial exposure can substantially improve both retention rates and long-term account values.
At-the-Money Results.
For the B+ minimum universe of 115 stocks, the retention rate progressively increases from 66.2 percent without relievers in Run No. 3 to 78.5 percent with relievers in Run No. 9, with a corresponding increase in account ratio from 69.7 percent to 80.3 percent. For the A- minimum universe of 50 stocks, the retention rate progressively increases from 79.9 percent without relievers in Run No. 4 to 92.7 percent with relievers in Run No. 10, with a corresponding increase in account ratio from 84.9 percent to 95.9 percent.
One-Step Out-of-the-Money Results.
For the B+ minimum universe of 115 stocks the retention rate progressively increases from 70.4 percent without rollovers in Run No. 5 to 76.9 percent with roll-overs in Run No. 11, with a corresponding increase in account ratio from 72.6 percent to 77.9 percent. For the A- minimum universe of 50 stocks, the retention rate progressively increases from 90 percent without rollovers in Run No. 6 to 96.2 percent with rollovers in Run No. 12, with a corresponding increase in account ratio from 91.6 percent to 96.8 percent.
Two-Step Out-of-the-Money Results.
For the B+ minimum universe of 115 stocks, the retention rate progressively increases from 71.1 percent without rollovers in Run No. 7 to 76.1 percent with roll-overs in Run No. 13, with a corresponding increase in account ratio from 73.6 percent to 77.5 percent. For the A- minimum universe of 50 stocks, the retention rate progressively increases from 95.7 percent without rollovers in Run No. 8 to 100.7 percent with rollovers in Run No. 14, with a corresponding increase in account ratio from 98.3 percent to 103.2 percent.