Increasing leverage through LEAPs

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al2000
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Increasing leverage through LEAPs

Post by al2000 » Thu Sep 11, 2003 11:00 am

Hi, all:

I have a question about increasing one’s leverage in trading. It involves buying LEAPs rather than the underlying stock. Here is how I envision using LEAPs. Suppose my equity is $100 K, and I want to risk 1% on a given trade. So, my risk is $1000. Suppose also that I want to trade the QQQ, which closed yesterday at 33.3. The ATR(20) for the QQQ is around 0.64. If I use a 2*ATR stoploss to set my risk, then I would have to buy 1000/2*0.64 or 780 shares of the QQQ. This would cost me 780 * 33.3 or $25,975. Using Interactive Brokers, the commission would be $78, so my out-of-pocket expenses are $26,050. My 1R stoploss would be 33.30 – 1.28 or 32.02. Now, instead of buying QQQ outright, suppose I buy the Jan ’04 LEAPs 32 call. As of last night, this call had a bid/ask of 5.0/5.2 (we’ll use 5.1 for this example). The delta of this call is 0.61. So, to have an equivalent position in the LEAPs call, I would buy 780/0.61/100 or 12.8 calls (rounding down to 12 calls). This would cost 12 * 5.1 * 100 or $6,120 plus $12 for commissions or $6132 equity allocation, giving me a leverage of 4.25:1. Now, when the underlying stock declines by 2*ATR (1.28 points), the call would decline by 1.28*0.61 or 0.78 points. So, my loss would be 0.78 * 12 * 100 or $936 (very close to the $1000 risk of loss owning the underlying stock). However, if the QQQ rose by, say, 3 points over the course of a few weeks or months, the call would increase by at least .61 * 3 or 1.83 points, giving me a profit of 1.83 * 12 * 100 or $2,196. However, the delta will likely advance as well since the call would now be almost 4 strikes ITM. So, the $2,196 profit is conservative at best, and it might even approach or even exceed the $3000 accruing for owning the underlying. So, in short, my risk is virtually the same as owning the underlying, and my profit potential is also very similar if not better. Yet, my equity allocation is only ¼ that of buying the stock outright. This would allow me to take on 4 times as many positions in other equity LEAPs, increasing my diversification and reducing my risk even further because of the added diversification.

You may ask, why LEAPs rather than shorter term calls? The answer is time premium. You don’t want theta decay working against you, even though you may only be in the position for a few weeks or so. And you choose a long term, ITM option to keep the time premium down to a respectable figure.

Does this make sense? Has anyone ever attempted this type of strategy? Are there any noticeable flaws I’m missing? One could argue that LEAPs are thinly traded, so the bid/ask spread may be too great to take advantage of this strategy. However, my counter to that argument is to stick with highly traded underlying stocks to begin with, which are likely going to be the higher cap stocks anyway. So, I don’t think thin trading volume has much weight as an argument against this idea. Any insights from the readers?

Jason Czech
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Post by Jason Czech » Thu Sep 11, 2003 11:26 am

Hi Al,

I've given a little thought to this kind of strategy as well. I think the biggest danger to this approach, you've already touched on, and that's the liquidity issue. I think it's true that you can get away with this most of the time, but what happens when there's a major panic in the markets & liquidity dries up in the derivitives? I think it would be pretty scary to be in a position of wanting to dump your LEAPs, and having no one on the other side of the trade.

To be honest, I haven't been around the markets long enough to experience anything like this. But I have read passages from a number of veterans who are very concerned about this type of situation. I think Henry Kaufman talks about it in "On Money and Markets" (A very interesting book, BTW), and he's a person who knows what he's talking about.

I'd also love to hear the thoughts of others on this subject.

-Jason

al2000
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Post by al2000 » Thu Sep 11, 2003 11:52 am

Hi, Jason:

It has always been my understanding that the options market makers HAVE to take the other side of the trade, by law, if the no. of options is less than or equal to 20 (of course, the bid/ask spread would likely be huge, but at least you'd be able to get out). Is this correct? Also, isn't the likelihood of what you describe rather remote, especially if you choose an option with a high open interest such as would exist with a heavily traded underlying stock?

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Post by enigma » Thu Sep 11, 2003 12:32 pm

hi Al,

I think under most situations, speculating with single stock futures will be better than using LEAPs... but of course, there aren't that many SSFs around at the moment.

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Post by Jason Czech » Thu Sep 11, 2003 12:52 pm

Hi Al,

You may very well be correct that the mm has to take the other side, but who's to say that their bid wouldn't be so far below the theoretical 'fair' price that it wouldn't make any sense to sell? I honestly dont know the rules, there may be some better safe guards built in. I took a look at the Jan 05 LEAPs for MSFT, and the volume looks extremely light for such an active stock.

http://finance.yahoo.com/q/op?s=MSFT&m=2005-01

It looks even worse on the QQQ

http://finance.yahoo.com/q/op?s=QQQ&m=2005-01

I don't know if this is typical volume though.

I know the likelyhood of something catastrophic happening is remote, but it's still a possibility that should be accounted for, in my opinion. Actually, I wonder what happened with optons expiring in May/June '88 on the day of the '87 crash? I don't think LEAPs existed at that time.

-Jason

al2000
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Post by al2000 » Thu Sep 11, 2003 1:04 pm

Enigma:

I like the concept of SSFs, but the problem with them is that they haven't been around long enough to do adequate backtesting. The LEAPs strategy would enable me to do the backtesting on the individual stock and just use the calls for doing the trading. I don't know if it is advisable to do backtesting of cash stocks as a proxy for the SSFs, if you wanted to do SSFs.

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Post by al2000 » Thu Sep 11, 2003 1:15 pm

Jason,

The open interest on the Jan 05 QQQ 32 calls is 25,782, while the open interest on the Jan 05 MSFT 25 calls is 92,379 and the 27.5 calls is 59,265. All 3 of these open interests are very high, suggesting that the issues are actively traded. I would have no problem trading with these open interest numbers. Also, look at the bid/ask spreads on those issues. They're really not that bad. An illiquid stock's bid/ask option spreads will be much greater. I'm not arguing with you; just wondering what you consider low open interest. Thanks for your post.

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Post by enigma » Thu Sep 11, 2003 1:19 pm

Hi Al,

You're right in that there aren't enough data for SSFs for proper backtesting and using the underlying stocks as a proxy for the futures may not be the best either :( But, I would have thought that the same logic would apply to LEAPs as well, since the value of the options are also affected by supply and demand, which are reflected by the implied vol. This means that you may need to backtest with historical prices of LEAPs and not with the underlying stocks. The implied greeks may sometimes be unreliable guides to the change in option prices.

Louis

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Post by Jason Czech » Thu Sep 11, 2003 1:47 pm

Al,

I see your point regarding the open interest and bid/ask spread. I guess that for myself I would want to see how these things behave under distressing conditions before making them a major part of my system. I don't know if options trade in Asia, but if they do maybe a look into these markets during the '98 financial crisis would provide insite.

Good luck with your research!

-Jason

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Re: Increasing leverage through LEAPs

Post by CRM114 » Thu Sep 11, 2003 1:55 pm

al2000 wrote:Using Interactive Brokers, the commission would be $78 ...
It doesn't really affect your argument, but I believe this should be $7.80.

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Post by Vince » Thu Sep 11, 2003 3:54 pm

I guess that if Leaps just gave you extra leverage for Stocks then you might as well use SpreadBetters where the margin requirement is 5%.

The beauty of the SpreadBetters is that you are guaranteed your exit price for as much as you want to sell/buy because you are betting on the price and not price and whats on the order book. Also the SpreadBetters track the actual order book prices...and I've never seen a difference between the order book and the Spreaders.

Thanks for the Leaps discussion.

Vince

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Post by al2000 » Thu Sep 11, 2003 4:25 pm

Vince,

What's a SpreadBetter? I've never heard that term before. Can you elaborate?

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Post by Vince » Thu Sep 11, 2003 4:34 pm

Hi Al,

SpreadBets are just another vehicle for trading instruments. You are betting whether the price will advance or decline.....as always. Margin requirements for the SpreadBetters are very low...for stocks its 5%. For the FTSE100 I thing it is £100 per point bet.

Check out www.deal4free.com

I think they now operate in the States, but I guess you have something similar over there anyway.

Vince

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Post by Vince » Fri Sep 12, 2003 3:13 am

I forgot to mention that you can bet on virtually any instrument, whether it be IR's, Currencies, Bullion, Commodities or Equities using the SpreadBetters.

Also, in UK, the wins are tax free.

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leaps vs shorter term options

Post by bmitchell » Wed Sep 17, 2003 9:53 am

The theta decay issue is an important one for shorter term options, but let's not get ahead of ourself here. If you are following trends, your successes wont have theta decay, because they will consist almost entirely of intrinsic value, with basically little/no time premium (this is assuming they make it to deep itm).

Second, with options, I don't know if trying to use stops makes sense. I'd generally take the perspective that if I had x$ to risk on stock, i'd buy no more than that x$ worth of options, for example if my risk was 2% and I had a 100k portfolio, i'd risk 2000$ on stock (using stops to limit risk) or 2000$ worth of options (no stops).

The reason for this is the volatility in options -- it is extremely likely you'd exceed your risk tolerance if you did otherwise, atleast that's been my experience.

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Post by al2000 » Wed Sep 17, 2003 12:06 pm

Your point about theta decay is correct. With LEAPs, theta decay is a relative non-issue for 2 reasons: the long time period where you are in the flat part of the decay curve and the fact that you are buying an ITM option.

However, regarding your second point, my suggestion was to ACT AS IF you were in the stock and get out of the trade if the STOCK declined to your 2% (or, in my example, 1%) stop level. In that case, you would be limiting your risk to whatever your risk percent was (1% or 2%), as my example demonstrated. Where you confused me was when you said you'd use the same risk in LEAPs as you would with stocks. The term 'risk' is not to be confused with 'allocation'. In other words, if your risk tolerance is 2% of equity, that is not the same as $2000 being invested in a stock. It's the amount you are willing to lose if the trade went against you. Your allocation would be a lot more than $2000. What I'm saying is that you use the same approximate RISK with LEAPs as you do with the underlying stock, except that it requires significantly less capital to make the trade using LEAPs. This, then, enables you to take on more positions and diversification than if you traded the underlying stock directly. Does this make sense?

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Post by bmitchell » Wed Nov 24, 2004 12:33 pm

This is a quite old post, that I never replied to. Sorry.

Anyways, sure that makes some sense, however with options, I tend to prefer to treat the premium as my stop. If I can risk 1000$ on a position, then i'll buy as much premium as that buys. The drawback of this approach is that a full investment is 100 positions @ 1% and 50 positions at 2%. The advantage is that short bursts of volatility do not remove you from the position. For long term trend following, I often buy atm rather than itm since I want gamma rather than delta.

Your approach is perfectly fine too, and does let you get away with a lot fewer positions, yet still have most of the advantages of trading an option strategy. In the context of my suggestion, risk and allocation are the exact same.
al2000 wrote:Your point about theta decay is correct. With LEAPs, theta decay is a relative non-issue for 2 reasons: the long time period where you are in the flat part of the decay curve and the fact that you are buying an ITM option.

However, regarding your second point, my suggestion was to ACT AS IF you were in the stock and get out of the trade if the STOCK declined to your 2% (or, in my example, 1%) stop level. In that case, you would be limiting your risk to whatever your risk percent was (1% or 2%), as my example demonstrated. Where you confused me was when you said you'd use the same risk in LEAPs as you would with stocks. The term 'risk' is not to be confused with 'allocation'. In other words, if your risk tolerance is 2% of equity, that is not the same as $2000 being invested in a stock. It's the amount you are willing to lose if the trade went against you. Your allocation would be a lot more than $2000. What I'm saying is that you use the same approximate RISK with LEAPs as you do with the underlying stock, except that it requires significantly less capital to make the trade using LEAPs. This, then, enables you to take on more positions and diversification than if you traded the underlying stock directly. Does this make sense?

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