This is the final method I am sharing on correctly sizing the position of each trade with proper risk management techniques. Use of LEAPS options for investing comes with lots of extra risk management requirements.
Options are truly a system of win or lose. When held until the expiration date, options are either worth something or they are worth absolutely nothing.
Options have various expiry dates. There are short-term options that can expire within days or weeks. These options are especially volatile in price and not very suitable for a longer-term trend investor.
LEAPS is a acronym for Long-term Equity Anticipation Securities. LEAPS options are identified as having expiration dates longer than one year from the current date. Although they are still risky, I believe a trend investor can use LEAPS strategies very profitably.
A Brief Concept of Options
Options—sometimes still called warrants on the buy side—are a contract between the option writer (seller) and a buyer to buy or sell a predetermined number of shares at a certain price on or before a date in the future.
When you hold an option, you have the right, but not the obligation, to exercise the option. You may also sell your option in the secondary market to another buyer.
Without even getting into the "Greeks", options are a land of jargon. Here's a brief rundown of the terms which are relevant for this article:
Options Contract: A contract between the writer and the buyer where the buyer has the right to buy or sell 100 units of the underlying security at the strike price on or before the expiration date.
Strike Price: The price at which the option can be exercised.
Expiration Date: The final date when the option is valid. At this time the option must be exercised (if in-the-money) or it becomes worthless.
Writer: An individual who sells the option.
Premium: The amount of money paid for the option. It is sometimes called the quote or option price in the secondary market.
Breakeven price: When the price of the underlying security is equal to the strike price plus the net premium cost.
Call option: An option where the holder has the right to purchase shares at the strike price.
Put option: An option where the holder has the right to sell shares at the strike price.
Covered option: An option where the writer actually holds the underlying security in question.
Naked option: An option where the writer does not hold the underlying security. (Writing is generally restricted to professional traders).
In-the-money (ITM): If the strike price of the option is greater than (call option) or less than (put option) the current price of the security.
Out-of-the-money (OTM): If the strike price of the option is less than (call option) or greater than (put option) the current price of the security.
Near-the-money: If the strike price of the option is very close to the current price of the security.
Bull spread: Buying a call option for a certain price and selling an equal amount of options on the same security for a higher price.
Bear spread: Buying a put option for a certain price and selling an equal amount of option on the same security for a lower price.
Straddle: Buying a call option and a put option for the same security at the same expiration date.
It is very important to understand that a buyer of options has limited downside, but a nearly unlimited upside. Their downside is limited to the premium they pay for the options contract they buy. Their upside is only limited by time—when the option contract hits the expiration date.
On the other hand, the writer has a limited upside, the premium they collect for selling the options contract, but a nearly unlimited downside. To their benefit, most options expire worthless or are otherwise closed in the writer's favour.
To the options buyer, the skewed risk presents some opportunity. It also makes for easy risk management in most market conditions. You cannot lose more than the premium you pay.
Especially when you start trading options, always buy in-the-money or near-the-money options to establish your position. Although far out-of-the-money options are much cheaper, they are also much less likely to hit the breakeven price.
Several Easy LEAPS Options Systems
Using LEAPS options as a strategy to get long or short exposure to a security should typically be based on a timing system. Although many people shy away from using options, it can actually be a very effective strategy if you take the time to understand how to execute and stay on top of your positions.
The exact system you use to get buy signals or sell signals doesn't really matter. As I have mentioned before on this blog, there are a wide range of effective indicators and none of them are perfect. They will all have losing signals and winning signals.
Some of the easier indicators include using a simple moving average, using a moving average crossover system, a breakout box system, or an absolute momentum system. All of these can be effective when paired with proper risk control.
Long-only LEAPS Options Strategy
The easiest way to use LEAPS options is to buy a liquid in-the-money or near-the-money call option when the underlying security hits a buy signal and a put option when the underlying security hits a sell signal.
Knowing that options can expire worthless if they are not in-the-money on or before the expiration date, you will only purchase the number of contracts which you can afford according to your maximum level of risk.
For example, if you are risking up to 1 percent of your portfolio value per trade, you will only purchase the number of options for this trade where the premium paid is up to 1 percent of your portfolio value.
Then, when the signal turns, you will either exercise the option or sell the option in the secondary market—whichever is more profitable. You cannot lose more than your initial risk (the cost of premiums to buy the options), but you can close trades very profitably.
Our trader has a $100,000 portfolio and is willing to risk 1 percent of his portfolio on a trade. That current translates to a maximum loss of $1,000.
On May 1, 2018 the price of the gold trust (GLD) made a new 3-month low at a price of $123.71 per unit. This signal was a sell-side breakout.
The trader used put option to bet on the further decline in the price of GLD. He could buy an in-the-money LEAPS put option expiring January 17, 2020 with a strike price of $125 for approximately $6.70 per unit. Since options contracts are sold in blocks of 100 units, he can only purchase one contract, risking $670.
On October 23, the price of GLD hit a 3-month high—a buy-side breakout—indicating a trend reversal by this strategy, the same put option is worth approximately $9.30 per unit.
With the new 3-month high indicating the trader to sell the put option at the current price of $9.30, the trader would sell the put contract for $930. This books him a profit of $260 on the trade, or 38 percent profit on the risk he took.
LEAPS Options Spread Strategy
A spread strategy using LEAPS options can be made of the bull side (betting on a rising price) or bear side (betting on a falling price). A spread trade reduces the overall cost of the premiums for the options, potentially increasing the total exposure.
To make a spread trade, the trader will buy options at an in-the-money or near-the-money strike price and sell the same number of options at an out-of-the-money strike price. This means the trader hopes to capture profit as the price of the underlying security moves within a predetermined range.
A spread strategy effectively limits the upside potential of a trade. However, the increased exposure can more than make up for this limited upside.
In a spread strategy, the trader will still ensure their total risk on the trade does not exceed their chosen percentage of their portfolio. This means the difference in the premium paid for the long option and the premium collected for the short option will not exceed their portfolio risk level.
If the signal changes, it is important for the trader to close both positions on the spread trade! They do not want to hold a naked option going either way, exposing themselves to further risk.
However, if the covered option the trader wrote goes in-the-money and can be exercised, the trader has a few different options to reduce risk. Some options the trader could consider includes:
- Cover both of the options contracts and close the position; or
- Cover the options contract the trader sold, but hold onto the options contract the trader purchased effectively changing to a simple long-only options strategy; or
- Cover the options contract the trader wrote and write new options at a strike price that is further out-of-the-money.
Using the same example of the sell-side trade on GLD for May 1, 2018 to October 23, 2018, the trader could place a bear spread trade using put options.
A bear spread trade would consist of two separate trades: buying a put option contract for one strike price and selling a put option contract for a lower strike price. This would cap the trader's upside, but would also lower the overall cost of the premium.
In the example of GLD used above, the trader will initiate a bear put spread 125:115 trade.
On May 1, 2018 when the price of GLD fell to a new 3-month low of $123.71 per unit, the trader purchased the same January 2020 put option for a strike at $125 for a premium of $6.70 per unit. However, this time the trader would also write a January 2020 put option at a strike of $115, collecting a premium of $3.20 per unit on that sale. The trader's net cost is $3.50 per unit.
Since the trader is willing to risk up to $1,000 total on this trade, he can double his trade size to purchase two $125 put options contracts for $1,340 and write two $115 put options contracts collecting $640. His net cost is $700, so that is his total risk exposure.
On August 2, 2018 the price of GLD fell below $115 per unit. The trader has some decisions to make based on the options above:
Option 1: The trader will close both positions since the $115 put contracts he sold are now in-the-money and can be called by the buyer at any time.
The value of the $125 put options has increased to $10.85 per unit and the value of the $115 put options increased to $4.70 per unit.
The trader sells his two $125 contracts for a total of $2,170 and purchases back the two $115 contracts for $940. His net receipts are $1,230 for a total profit of $530. That's a 76 percent profit on his $700 initial risk.
Option 2: The trader purchased back the $115 put options that he wrote in May for their current value of $940. He holds onto the two $125 put contracts until the signal changed, effectively changing his bet to a simple long put.
If the trader continued this trade until October 23 and sold their two $125 put contracts for $1,860, he would have booked a profit of $220 on the full trade. That's 31 percent profit on his initial $700 risk.
Option 3: The trader buys back the two $115 put options contracts for the current value of $940. He wrote two new $110 put options contracts at $2.85 per unit and collected a premium of $570.
The price of GLD never hit $110 per unit. If the trader were to close his positions on October 23, he would sell the two $125 put contracts for $1,860 and cover the two $110 put contracts he wrote for their current value of $420.
After factoring in the cost of covering the $115 put contracts back in August, the profit on the trade would be $370. That nearly equals 53 percent of the trader's initial risk of $700.
Steps to Calculate Your Position Size Using LEAPS Options
These are the steps to identify all the components you need to complete a proper calculation of maximum position size using LEAPS options.
- (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
- (LO) Identify the current price of the in-the-money option. I highly recommend traders use in-the-money or near-the-money options to establish their position.
- (SO) Identify the current price of the out-of-the-money option. The out-of-the-money option pricing is only required if the trader is using a bull spread or bear spread strategy where they will be selling out-of-the-money options and collecting the premium.
- (P) Determine the price of the options contract. Options are traded in contracts of 100 share blocks. The options contract price should be the price of LO or SO multiplied by 100, plus the trading cost.
The calculation for maximum position size using the Long-only LEAPS options system is as follows:
R/(LO*100) = C
C = Maximum number of full contracts to buy
or, in a single, simplified calculation:
[R/(LO*100)]*P = Total Position
The calculation for maximum position size using a LEAPS options spread strategy is as follows:
R/[(LO*100)-(SO*100)] = C
C = Maximum number of full contracts to buy and sell
or, in a single, simplified calculation:
R/[(LO*100)-(SO*100)]*P = Total Net Position
This example will be a position size calculation using the more complex LEAPS options spread strategy for the iShares Russell 2000 ETF (IWM), using a 3-month breakout system.
To demonstrate how it works, we will use the entire time period of the most recent full trade for IWM. The long entry on the green line would have occurred on May 10, 2018 when the price closed at $159.53. The exit signal red line would have been on October 4, 2018 as the price closed at $163.64.
- (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
- (LO) Identify the current price of the in-the-money option. The nearest round number option has a strike price of $160. The price of the January 2020 IWM $160 call option was approximately $14.10 per share. Therefore LO = $14.10.
- (SO) Identify the current price of the out-of-the-money option. We will sell a call option with a strike price of $180, which is more than 10 percent away from the current price. The price of the January 2020 IWM 180 call option was approximately $5.60 per share. Therefore SO = $5.60.
- (P) Determine the price of the options contract. Options are traded in contracts of 100 share blocks. Therefore one contract of LO = $1,410 and one contract of SO = $560.
R/[(LO*100)-(SO*100)] = C
Calculation for C: 1000/[(14.1*100)-(5.6*100)] = 1.18 contracts
C = 1 full contract for each trade
Calculation for Total Net Position: (1*$1,410)-(1*$560) = $850
The maximum net position of IWM for this trader establishing a bull call spread on May 10 will be $850.
The trader will enter a purchase order to buy 1 contract of IWM 160 option expiring January 2020 for a cost of $1,410. The trader will sell 1 contract of IWM 180 option expiring January 2020 for a premium income of $560.
During this trade period, the price of IWM did not hit $180. The initial trade was in effect the entire period. On October 4, 2018, IWM hit a 3-month low calling for an exit of the position.
In this example, the trader sold the single January 2020 IWM 160 call option contract for $1,620 on October 4. The trader then covered the single January 2020 IWM 180 call option by repurchasing it for the current price of $615.
The net sale price was $1,005 while the position cost $850 to establish. The trader realized a profit of $155, or 18 percent on their initial risk. A profitable trade!
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