Beat The Market By 400% With SPY LEAPS Options

[OddTrader]

Beat The Market By 400% With SPY LEAPS Options
Nov. 14, 2011

http://seekingalpha.com/article/307574-beat-the-market-by-400-percent-with-spy-leaps-options

Investors looking to beat the market may want to consider trading LEAPS options to add a little leverage to their position without taking on too much risk. The term LEAPS is actually an acronym for Long-term Equity Anticipation Securities, which are options that have expiration dates one to two years in the future. (Most regular options are traded with expirations within 9 months or less).

Continued at above link...

 

[blueplayer]

From the original quote:
Keep in mind that if a LEAPS call option was purchased, the underlying stock would have to be above the strike price by the expiration date, otherwise it would expire worthless. The $130 strike price that we picked is only 2.6% higher than the current price of SPY. Therefore, the market needs to move only 2.6% by the January 2013 expiration date to squeak out a profit. If the market only moved by 2.6% in that time frame, you would still have a gain of about $167 or 16.7% with the LEAPS call option. However, if the price of SPY was $129.99 or lower at the time of expiration, you would lose the entire $995 price of the call option.

The market would have to move way more to be break even. I guess the guy who wrote the original article in seeking alpha has a magic broker that provides him with free options. For the rest of mortals that have to pay for them, in order to break event the market will have to close above 139.95 (130+9.95 cost) a move more than 10.48% (not 2.6% as was claimed).

 

[just21]

Cornwall capital in the big short by Michael lewis supposedly went from $110,000 to $35,000,000 trading leaps on special situations. I think they may have added capital to the original starting capital but still a very impressive return. Their thesis,having read how to be a stock market genius by Joel Greenblatt (the guy who asks Michael Burry for his money back in the Big Short movie), is that Leaps are not priced correctly for special situations.

 

[OddTrader]

http://www.elitetrader.com/et/index...eir-leaps-on-capital-one.278335/#post-3874821

I'm doing some research on LEAPS as a form of investing. I love the prospect of betting on out of favor stocks through LEAPS that seem poised for big changes, such as what Cornwall Capital did back in 2003 with their bet on Capital One rallying post-investigation.

However, I don't understand the math. Simply, I'm confused. If Cornwall bought 8000 LEAPs priced a little more than 3 bucks on Capital One with a strike price around 40, how on earth did they bag 526,000 dollars after Capital One's stock shot up post-investigation, well past the strike price. It apparently was hovering somewhere around 30 when they placed their bet.

Can someone please spell out the math for me on this one? Isn't each LEAP a total of 100 shares. How did 26,000 become 526,000?? I read the section in Michael Lewis's The Big Short, but I don't get the math.

Can someone write out the exact arithmetic for me? I am a neophyte but am trying to educate myself on investment finance.

Thanks so much!

I just looked up the passage in the book. It looks like they bought 80 LEAP contracts (each for 100 shares), at a 40 strike price, for a cost of about $26,000 (80 LEAPS *100 shares/leap * approx. $3.25). At expiration, those contracts break even at a stock price of 43.25, and every 3.25 thereafter they make another multiple of the initial investment. Before expiration they will be worth even more since there will generally still be time value remaining in the option. They cashed out at $526,000, for 20 times their initial investment, which if held to expiration two and a half years later would require the stock to be a little over 95. Capital One's stock price was in the 60s by September 2003 and hit the mid-80s by the end of 2004, well before the options expired.

Thank you so much for your response.

I understand quite a bit more now on how to calculate the difference, but I did some calculations and am still a little confused--

95.25 - 43.25 = 52 in the money

52 / 3.25 = 16 multiples

so 16 * 26000 = 416000 dollar profit after exercising the LEAPs

or 52 * 80 LEAP bundles * 100 shares per bundle = 416000 dollars

where's the rest of the 526000 dollars--the 110,000 ?

Did they exercise the LEAPS at a bit higher than 95, say around 13.75 higher, around 109??

That allows for the arithmetic to add up-- (109-43.25) * 8000 = 526000

Just trying to have as much clarity as possible on how this stuff works.

Thanks so much for your help

Happy to help. I had accidentally used 30 instead of 40 for the expiration profit calculation, so you are right, at expiration to achieve that return the stock would have to have been around 105, which the stock never reached. The key thing to realize is that when they sold the options there was time value left, making them worth potentially quite a bit more than the intrinsic value (stock price minus strike price).

This page may be helpful in explaining how call options are valued: http://en.wikipedia.org/wiki/Call_option

 

[ironchef]

The market would have to move way more to be break even. I guess the guy who wrote the original article in seeking alpha has a magic broker that provides him with free options. For the rest of mortals that have to pay for them, in order to break event the market will have to close above 139.95 (130+9.95 cost) a move more than 10.48% (not 2.6% as was claimed).

This, plus if I apply Capital Asset Pricing Model (in modern portfolio theory) to calculate risk vs return, I can calculate the expected return using the beta calculated from BSM. The academic studies I found all said actual risk-return of call options from historical data were not as good as what CAPM predicted.

Perhaps MMs already priced in the potential gains from options leverage? - (e.g., Jun 2016 SPY205 Call IV=14.4% Mar 2018 SPY205 Call IV=16.9%. Vega for 2018 call is 1.09, so MM is pricing $2 extra for LEAPS), i.e., no free lunch?

 

[El OchoCinco]

CAPM is not really a tool to use in analyzing an options position. You said you never studied finance but are throwing around BSM and CAPM... did you read these somewhere?

 

[newwurldmn]

The whole point if trading is that you believe capm is wrong.

 

[ironchef]

CAPM is not really a tool to use in analyzing an options position. You said you never studied finance but are throwing around BSM and CAPM... did you read these somewhere?

Yes, I am an engineer by training but smart enough to ask professor Google.

And tried to appear like I knew what I was talking about.

 

[blueplayer]

Cornwall capital in the big short by Michael lewis supposedly went from $110,000 to $35,000,000 trading leaps on special situations. I think they may have added capital to the original starting capital but still a very impressive return. Their thesis,having read how to be a stock market genius by Joel Greenblatt (the guy who asks Michael Burry for his money back in the Big Short movie), is that Leaps are not priced correctly for special situations.

They were not priced correctly at that time, I think when they were introduced they were really underpriced in vega (wrong modeling perhaps?) so you could play earnings events with fantastic risk reward. Of course nowadays I can bet you that the mispricing is not there anymore (because of everyone knowing about it since many years ago).