Showing posts with label leaps-nse. Show all posts
Showing posts with label leaps-nse. Show all posts

## Out-of-the-Money LEAPS- Introduction

Out-of-the-Money LEAPS

Introduction

We saw that restricting the sale of at-the-money LEAP puts to better stocks could significantly increase the proportion of LEAPS that would expire worthless, thereby reducing financial risk and increasing retention rates and ultimate profitability. Another way to reduce risk while maintaining adequate retention rates is to sell LEAP puts that are one or more steps below the at-the-money exercise price. However, although writing out-of-the-money puts is certainly safer than writing at-the-money puts, the premiums will be correspondingly smaller because of the reduced level of risk involved.

My study employs two series of computer runs. In the first series, I repeat the simulations performed in Runs No. 3 and 4, but this time all of the strike prices are set one step below the at-the-money exercise prices used earlier. Recall that strike price intervals for LEAP (and standard) options are set in increments of \$2.50 when the stock price is between \$5 and \$25, in increments of \$5 when the stock price is between \$25 and \$200, and in increments of \$10 when the strike price is over \$200. For a stock price of \$21, for example, the at-the-money strike price is taken as \$20, so the one-step out-of-the-money strike price is going to be \$17.50.

In the second series, we repeat the simulations, but this time with all of the strike prices set two steps below the at-the-money exercise prices used before.

One-Step OTM LEAPS on the B+ Minimum Universe

Run No. 5 is the analog of Run No. 3, in which the sale of LEAP puts was restricted to the 115 stocks in the B+ minimum universe, but this time the strike prices are set one step out of the money. As shown in Table, the number of LEAP contracts written is again 25,302, with 21,858 contracts expired and 3,444 still active on March 31, 1997. The percentage of options expiring out of the money increases from 84 percent in Run No. 3 to 92.5 percent.

Setting the exercise price one step below the ATM strike price reduces risk significantly but heavily impacts the premiums received. This can be readily observed by comparing the \$2,066,174 in premiums collected for the expired LEAP puts in Table against the \$3,992,382 in premiums. On the other hand, the overall retention increases from 66.2 percent. Account value as a percentage of total premiums collected is up from 69.7 percent.

One-Step OTM LEAPS on the A- Minimum Universe

Run No. 6 is the analog of Run No. 4, in which the sale of LEAP puts was restricted to the 50 stocks in the A- minimum universe, but this time with the strike prices set at one step out of the money. As shown in Table, the number of LEAP contracts written is again 11,520, with 10,018 contracts expired and 1,502 still active on March 31, 1997. The percentage of options expiring out of the money increases from 87.1 percent in Run No. 4 to 95.1 percent.

Setting the exercise price one step below the ATM strike price again reduces risk significantly and again heavily impacts the premiums received: compare the \$649,621 in premiums collected for the expired LEAP puts against the \$1,440,155 in premiums. And again, the overall retention rate increases from 79.9 percent. Account value as a percentage of total premiums collected is now 91.6 percent, well ahead of the 84.9 percent.

Two-Step OTM LEAPS on the B+ Minimum Universe

Run No. 7 is the analog of Run No. 3, in which the sale of LEAP puts was restricted to the 115 stocks in the B+ minimum universe but this time with the strike prices set at two steps out of the money. As shown in Table, the number of LEAP contracts written is again 25,302, with 21,858 contracts expired and 3,444 still active on March 31, 1997. The percentage of options expiring out of the money increases from 84 percent in Run No. 3 to 95.6 percent.

As you might predict, setting the exercise price two steps below the ATM strike price greatly reduces risk but also impacts the premiums received even more dramatically. Compare the \$1,136,869 in premiums collected for expired LEAP puts against the \$3,992,382. The overall retention rate increases to 71.1 percent from the 66.2 percent. Account value as a percentage of total premiums collected is now 73.6 percent, up from 69.7 percent.

Two-Step OTM LEAPS on the A- Minimum Universe

Run No. 8 is the analog of Run No. 4, in which the sale of LEAP puts was restricted to the 50 stocks in the A- minimum universe but now with the strike prices set at two steps out of the money. As shown in Table, the number of LEAP contracts written is again 11,520, with 10,018 contracts expired and 1,502 still active on March 31, 1997. The percentage of options expiring out of the money increases from 87.1 percent in Run No. 4 to 97.1 percent.

The other results are entirely predictable. Premiums collected for the expired LEAP puts total \$330,155 in Table compared with the \$1,440,155. The overall retention rate increases from 79.9 percent to 95.7 percent, and account value as a percentage of total premiums collected is now 98.3 percent, well ahead of the 84.9 percent.

RUN NUMBER 5

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
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 6

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
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

RUN NUMBER 7

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
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 8

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
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

To compare the results obtained, let's again tabulate the OTM rate, the retention rate, and the overall ten-year value ratio for the runs done so far.

Table  Figure of Merit Comparisons

As seen in Table, for the B+ minimum universe of 115 stocks, the proportion of LEAPS expiring worthless is seen to rise from a low of 84 percent to 92.5 percent to 95.6 percent as exercise prices are moved further out of the money. The corresponding retention rates and account ratios improve somewhat: retention rates move from 66.2 percent to 70.4 percent to 71.1 percent, and account ratios move from 69.7 percent to 72.6 percent to 73.6 percent. For the A- minimum universe of 50 stocks, the proportion of LEAPS expiring worthless is seen to rise from a low of 87.1 percent to 95.1 percent to 97.1 percent as exercise prices are moved further out of the money.

This time, however, the corresponding retention rates and account ratios improve significantly, the former going from 79.9 percent to 90 percent to 95.7 percent, the latter moving from 84.9 percent to 91.6 percent to 98.3 percent. What all this tells us is that by writing out-of-the-money LEAP puts on better-quality stocks, it is possible to bring up the proportion of LEAPS expiring worthless to levels well over 95 percent and achieve premium retention rates of 90 percent or more, with account ratios as high as 98 percent of the total premiums collected.

Mind you, these results are calculated from the sale of a random number of out-of-the-money LEAP puts on a random number of these better-quality stocks on a random schedule throughout each year over a ten-year period. As such, they do not reflect any tactical decision making or any involvement on the part of the investor other than his or her investing the net premiums in money market funds. The investigates the extent to which the above results can be improved by using a simple recovery-and-repair strategy in those situations where LEAP contracts appear to be expiring in the money as their expiration dates approach.

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