ZERO INTOLERANCE
by Brent L. Leonard, CMT
Nearly a decade ago I stumbled across a conservative equity investment strategy that, for some reason, is largely ignored. Possibly because it seems counterintuitive, although when thought through, seems logical and has served me well over the years – especially in today’s debatable extended stock market. It also uses the oft maligned concept of stock options, specifically DITM ( deep-in-the-money) call options.
In a market such as today’s extended and often Volatile state, DITM can offer a bond-like return with more safety than “naked”, or unhedged stocks – no matter how fundamentally sound they are. To cite an example of how it would work:
An investor purchases ABC stock for $50 per share, in the form of a Buy/Write selling a $45 call option shortly before ABC is due to go ex-dividend for a rate of @3%; since dividends occur in U.S. stocks quarterly, let us presume the call is around 4 to 5 months until expiry, thereby receiving 2 dividends. At first look, this seems to guarantee an automatic loss! However, since the option contains both the intrinsic value of the $5 presold amount plus $1 or 2 extrinsic time premium, this stipend can be reinvested immediately upon sale (one can almost opine that they bought the stock at a 10% discount of $45 instead of $50).
It would be optimal if this quality stock took a previous drop for some reason, raising the Implied Volatility (IV) making the premium (aka juice) of the call option briefly. So not only is one providing a safety net of several points of oscillation sans worry, but allowing for a stop loss order in case of an imminent Bear market to provide a warning time.
If they do this trade 3 times a year with the same or similarly researched stock, double-digit returns are quite probable, with less risk and worry. Taxation would be of short term gains, unless done in a tax exempt account, such as an IRA , 401K, et. alia.
Purists would argue that the ultimate objective of capitalistic stock markets is to Buy-and-Hold ( to which I agree if one enters them when young – say with a 401K, IRA, etc.; DITM is also not a day traders’ way to get rich either. It is somewhere in between. Naysayers also would argue that the maximum benefit of stocks is Appreciation, but if a DITMer wants to “roll up and out” the call – buying it back when premium has disappeared due to a stock rising far enough, more “juice” can be obtained selling a higher call ( although still well in-the-money) but farther out in time.
Similarly, if the stock drops too far, one can buy back the previously sold call much cheaper ( due to time and price decay) and sell another call lower – the dividend being the same amount, but higher percentage as the stock price is now lower.
