Traditional Positions vs. LEAPS Options

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:

Source: StockCharts.com

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!

Source: TheRichMoose.com

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.

Source: TheRichMoose.com

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:

Source: Marketwatch

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?

Traditional Trade

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.

Summary

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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A Current Look at Relative Momentum Across Equities

Coming to the close of 2018, we're seeing an incredibly divergent year in equities markets across the world.

This stands out when we think back to just a year ago where every market across the world seemed to be going straight up. Beyond broad equities and the scope of this post, we had crypto going nuts, pot stocks exploding higher, tech companies across the world soaring, and private equity was simply insane.

Just eleven months later, hardly anything is left standing. Equity markets, the highly liquid indicators of investor optimism on the economy, have shrunk quite shockingly across the globe. Only the U.S. market is hobbling along, but it's also looking shakier by the day.

I'm not ready to declare we're officially in a global bear market yet but, given that the MSCI ACWI Index (in USD) has declined more than 15 percent from the peak, we're sure getting close.

US Stocks vs. European Stocks

Source: TheRichMoose.com, MSCI Inc.

If we look at the above chart, we can see the very clear divergence of these markets which started in May 2018.

While both the U.S. and Europe had a sharp pullback in late January and February, the U.S. recovered into September while Europe kept on sinking.

At this point, when priced in U.S. dollars, European stocks are down nearly 15 percent for the year and nearly 20 percent from the January peak.

U.S. Stocks vs. Japanese Stocks

Source: TheRichMoose.com, MSCI Inc.

Japanese equities were outperforming U.S. stocks in the beginning of this year. In fact, Japan had a great year in 2017.

But, like the other major developing markets, Japan couldn't work past the January 2018 high point despite being positive for much of the year.

Finally, in May, Japanese stocks diverged and are now down more than 5 percent on the year. They are also down over 15 percent from the peak in January.

U.S. Stocks vs. China

Source: TheRichMoose.com, MSCI Inc.

We see a similar pattern in Chinese stocks. Again, the year-to-date chart shows a big divergence beginning in May 2018.

The Chinese market was actually booming earlier this year and showed strong relative momentum compared to U.S. stocks.

Like European stocks, Chinese stocks never recovered after the January peak. They are down over 20 percent this year and have a peak decline in excess of 35 percent within 2018 alone!

Market Cycle Performance

If you look across this entire market cycle, it is clear: U.S. stocks, particularly technology stocks and small cap stocks, have been the major winners.

Investors in foreign markets have gone almost nowhere since the beginning of 2008.

Source: TheRichMoose.com, MSCI Inc.

While it is looking like the global equity bull market is ending for the 2009 to 2018 up-cycle, most investors haven't been richly rewarded. Especially if they bought heavily near the end of the previous up-cycle cycle in 2007-2008.

Nearly every major equity market has experience a ten year gross cumulative return of less than 20 percent! Japan looks comparatively good at around 30 percent.

During this same time frame though, an investor in the U.S. equity market would have more than doubled their money.

This level of global divergence is incredible. We have yet to see how the down-cycle ends up, but given the strong declines across many foreign markets, we could have some great entry points in the future.

The last time we saw a level of divergence even close to this in a equity market up-cycle was in the 1990s. We know the next up-cycle starting in the early 2000s proved to be fantastic for the investors who chose the markets that were under-performers in the 1990s.

I think it would be very smart for investors to look for good entry points in many commodity producing markets, several of the more depressed European markets, and in China and India.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.