Options have inherited strengths compared with vanilla stock positions, and it’s important to play to those strengths and try to minimize exposure to the weaknesses. This is the first part in a series where I’ll elaborate on the strengths of trading leap options.
In this part I wish to suggest a really simple strategy to increase the profits while minimizing the risk. The strategy is simple – it requires simply buying a leap call to take advantage of an expected rise in stock prices (Options as stock-replacement) . The call serves as a leveraged equivalent of buying 100 stocks. If you keep that ratio – 1 option = 100 stocks – the maximum loss is lowered, even if the position is leveraged.
Barron’s Round Table
To show this I wish to use an example from Barron’s magazine. In the start of 2013 (and start of 2014), Barron’s sat down with several very successful investment professional to a round-table discussion on which stocks will out perform the following year. The article itself is locked for subscribers only but the magic of Google will let you find what you want. This is the most recent round-table.
Trading Leap Options
In this example I used the round-table’s 2013 recommendations. I took In-The-Money leap calls that were at least 10% ITM and expired 1 year later – on Jan 2014. We had 22 optionable stocks to check out of 43 recommendations (today we have more optionable stocks). In the backtest I “bought” the options at Jan-11 2013 and “sold” them on 31-Dec 2013. For comparison I also checked the stock yield for buying 100 stocks of each ticker. Here are the results:
- We can see that the recommendations were successful, yielding 18.5% percent for the year.
- The Options were much more leveraged, they yielded almost 100% for the year.
- The average $ profit of stocks ($714) is higher than the average $ profit of an equivalent option position ($618). This is mainly due to the time value inside the option that decayed as the year passed.
- Even so – It’s Important to remember that the average stock position was 6.25 times bigger than the option position.
- The fact that option position is smaller than stock position but yields almost the same results often used to increase leverage. Often It’s better used to diversify the portfolio over leveraging it.
- Because options have limited loss but unlimited gain potential, we can see that in 4 trades the option lost less in dollar amount compared to the stock.
- Leap options can be good replacements to stock positions. The limited loss unlimited profit potential is great when you expect great stock movements.
- Options are leveraged instruments. We can see an example where the stock lost 2.5% but the option lost 75%. Manage risk first.
- We can see the real upside of holding diversified positions of leap calls where they gained average return of almost 100% when the average stock return was 18.5%.
How to Find Leap options to trade
You can use Option Samurai to scan for leap calls to trade (click here for demo). Simply change the expiration date and the stock score and sort the columns to find trades: