Over the past several months, I have made a major shift in how I execute my trades. I still follow trends: betting on the upside when prices are moving up and betting of the downside when prices are moving down; however, I have almost completely avoided taking a traditional position.
By traditional position, I mean buying X many units of XYZ and holding onto that position. Or, on the downside, short selling units of XYZ and holding the position until the trend changes direction.
Instead, I am using LEAPS options (long-dated options) on most of the ETFs I track to execute my trades. I can buy call options to bet on upside movements and I can buy put options to bet on downside movements.
This shift allows my to use my trading capital much more efficiently, reducing my risk exposure and increasing my potential portfolio profits.
Traditional Position Sizing Example
Taking a position in this traditional method amounts to a very inefficient use of capital. Lets use the current price of SPY (the biggest ETF) as an example:
Using a simple Keltner Channel indicator, lets say we will enter the trade when it crosses $267 and we'll have a stop at $252. If we have a $100,000 account risking 2 percent of capital per trade, this would be our exposure:
Units = R/(P-S)
R = $100,000 x 0.02
R = $2,000
P = $267
S = $252
Units = $2,000/($267-$252)
Units = 133
Position = Units x P
Position = 133 x $267
Position = $35,511
This means we would have to use more than one-third of our capital to enter this one position for $35,511. This means we only have $64,489 left in our account to add more positions, either limiting our diversification or forcing us to access margin loans.
On the risk side, we will sell our position if the price falls below our stop level of $252, which would result in a loss of $2,000. Our stop will rise if the price of SPY continues to rise, hopefully resulting in a profit before we eventually exit the position.
Understanding Options Contracts
Now, lets look at the exact same trade using LEAPS options. In this case we are betting on the upside; in the wide world of options trading we can execute this trade in two ways: we can buy call options or we could sell put options.
While both trades would bet on the upside, the difference in risk and mindset is extreme!
When we buy a call option, we are initially in a small but limited loss because we pay a premium for the option contract. However, as we cross the point where the price of the security (in this case SPY) exceeds the cost of the strike price and the premium paid, everything is incremental profit.
In other words, limited and highly controlled downside with very high upside potential.
When we sell a put option, the premium we collect is the most money we will ever make on that trade: instant maximum profit. If the security (SPY) goes up, we do not collect any more money. However, if the price of the security goes down, we begin to lose money.
If the price of SPY falls below the strike price minus the premium collected, we are showing a loss and the loss will grow incrementally from there if the price of SPY continues to fall.
For this reason I never write (sell) options! I would rather control my downside than my upside. However, the appeal of instant profit when writing options is very alluring so this is a popular strategy for investors to earn income. Unfortunately, many are blind to the risks.
Position Sizing with Call Options Example
In this example, we will take an upside position in SPY using the exact same risk parameters as we did in the previous example. There are many ways to make this trade, but for the sake of simplicity we will use a January 2020 LEAPS option with a strike price at $265—an "at-the-money" option trade.
First, we will need to take a look at the price of the options by viewing the "Options Chain" for SPY:
We can see here that the price of the option with a strike of $265 is $19.19 today. Now, options must be bought or sold in contracts that are groups of 100 units. So one contract equals exposure to 100 units of SPY.
In this case, we are again willing to risk $2,000. Since we must get exposure to 100 units, one contract would cost $1,919 while two contracts would cost $3,838. Given our risk, should we purchase one or two contracts?
We know our exit point is $252, meaning we will close our position if the price reaches that point. If we buy a single contract, we know that we would never lose more than the premium we initially paid: $1,919. However, can we get more exposure while maintaining our risk?
To get a clue, we can look up the options chain. When SPY is $252, our $265 call option will be $13 out-of-the-money. Today, a call option that is $13 out-of-the-money is valued at $10.85. We can imply that if we sold a two contract position tomorrow, we could recoup $2,170 for a net loss of $1,668.
Given the overall margin of safety and our stop loss level, it is quite safe to purchase two contracts of SPY at a strike price of $265 when executing this trade. Again, that gives us exposure to 200 units of SPY for a total cost of $3,838 (or 3.8 percent of our total capital).
Profit Potential: Traditional vs. LEAPS Options
After extensively looking at our downside risk, we need to compare the end result of a profitable trade. Lets assume the price of SPY rose considerably over the next six months and we receive a signal to exit at $290. How much money would we make?
In our traditional trade we purchased 133 units of SPY for $267 per unit for a total outlay of $35,511.
If we sell 133 units at $290 per unit, we will get $38,570 in proceeds (minus trading commissions). That equals a profit of $3,059 on the trade.
Our percent return on capital employed would be +8.61 percent. Our return on our portfolio value would be +3.06 percent.
LEAPS Call Option Trade
In our LEAPS call options trade, we bought two contracts of SPY with a strike of $265 for January 2020. The total outlay, or cost to us, was $3,838.
If we sell two contracts of SPY with about six month left when the price is at $390, we can look at the current call options expiring in June 2019 for a clue on the price. Our options would be $25 in-the-money, so we will consider the current price of a $242 June call option on SPY.
Currently, June call options with a strike of $242 are valued at $29.75. This suggests our options could sell for roughly the same value. (Volatility at that time and the exact number of days remaining before option expiry will impact the true price).
Using these estimates, if we sell our two contracts for January 2020 call options at a strike of $265 when the price of SPY is $290, we could collect $5,950 (minus trading commissions). That equals a net profit of $2,112 on the trade.
Our percent return on capital employed would be +55.03 percent. Our return on our portfolio value would be +2.11 percent.
Using LEAPS options on popular ETFs allows the investor to use their trading capital much more efficiently when taking positions.
Using simple risk metrics, it would not be uncommon for an investor to deploy 25 to 50 percent of their capital on a single trade if they purchased broad index ETFs in the traditional method.
With LEAPS options, an investor may deploy less than 5 percent of their capital to execute a comparable trade on the same security. This allows them to make many more trades without taking on margin debt or other loans.
Traditional purchases of ETFs can allow the investor to make a higher return on their total investment capital. This is because there is no time decay or volatility costs when holding the position. That said, LEAPS options are much more efficient overall when measuring return on capital employed.
Unlike traditional investing where the price is the price, LEAPS options allow for great flexibility in executing trades. Buying deep in-the-money options can significantly reduce time and volatility costs, but will increase total capital outlay (while still being a fraction of the traditional outlay). Using out-of-the-money options will increase time and volatility costs, but can massively increase exposure.
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