DLS-PAPER TRADE #2
CONTINUATION
Our monthly income goal: $40,000 / 12 months is $3,330
What leap expiration? What strike price for the leap?
I go out to the furthest one available. If I was actually opening this position i probably would wait until the January 2013 IWM leaps become available in the fall, but the furthest out right now is the January 2012. Reason? the theta of the leap is minimal and the time value per day is smallest.
I pick a strike DITM and one with at least a delta of 0.80. Reason: there is very little time value at that delta. A major risk of diagonal spreads is changes in implied volatility (vega effect). These changes effect only time value therefore we have minimized the vega effect in our position. (not totally eliminated it).
Therefore, for our leap position I have chosen the Jan12-50 strike trading at $23.36 with a delta of 0.84.
How many leap contracts should we purchase?
In our buy-hold portfolio we had $200,000 to allocate for the purchase of IWM. At $69.56 we would have purchased ($200,000/$69.56) or 2875 shares. The equivalent stock position using leaps would be 2875/delta of 0.84 or 3423 shares or 34 contracts. Since we will be legging into the full dls position over 3 months I will use 3300 shares to make calculations easier. That would be 11 (1100 shares) contracts per month for 3 months.
We will purchase 11 contracts now and sell short calls with expiration of Aug10.
At June option expiration we will purchase 11 more leap contracts and sell short calls with Sept10 expiration and at July expiration we will purchase the remaining 11 leap contracts and sell short calls with Oct10 expiration. We will, at July expiration, have our desired dls position of 33 contracts.
Initial leap cost = 1100 * $23.36 = $25,696
TO BE CONTINUED
--- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@...> wrote:
>
> Mike Cleveland posted this recently:
>
> "One thing that would really benefit me, and possibly others, would be to "start from scratch." I'm sure you have done this in your paper, but it would be nice to be able to discuss it together to help clarify, for people like me who are new.
>
> It would be good to do a "From the Beginning" post. What is a "DLS?" How do you find good trading candidates? Do you do any ETF "DLS" trading? How far out in the future do you look for candidates? What strike prices? How do you enter? When do you adjust?
>
> If you just did one post per day, starting with the basics, it would allow us to follow along and ask questions.
>
> Would you consider this?"
>
> Most of the answers are in my paper. I am modifying the expiration date for the short calls and will revise the paper when i get a chance.
>
> I can establish an initial dls position and go through the mechanics. However, once established it is pretty boring. Really nothing to do until expiration of the short calls which i am going to change from a one month sc to a 3 month sc which i will explain shortly.
>
> 1) Critical: establish a buy-hold portfolio
>
> For simplicity, let's say you have a $500,000 retirement portfolio and you would like to allocate 40% into equities and 60% into fixed income.
>
> Equities 40% is $200,000. I trade only diversified ETF's and the one's I use most often are SPY, IWM, EFA and EEM. I believe it is very difficult to be successful trading the dls strategy using less than 10 contracts initially. If your capital only allows 10 to 15 contracts trade only one of SPY, IWM or EFA. EEM is too risky, imo, if you can only trade one ETF in the dls strategy. Again for simplicity, let's choose to use all the $200,000 trading IWM in the dls strategy.
>
> 2) Next we have to select a % return goal for your $500,000. Remember, each of us have different goals and we will not all select the same goal. For this example, I will select one. Since returns are higher with more risk and lower with lower risk and since dls portfolio strategy has significantly less money at risk than a buy-hold portfolio I am going to select a 10% annual return on our $500,000 or $50,000 per year.
>
> A diversified bond ETF is yielding about 4%. If we put our $300,000 fixed income portion in that we should return about $12,000 per year. If we set a 20% return on our dls portion, $200,000 * 20% is $40,000. The $12,000 and $40,000 yields $52,000 which is a 10.4% portfolio return.
>
> Summary:
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> Portfolio:
>
> $300,000 in a bond ETF (like BND) goal 4% or $12,000
> $200,000 in IWM using dls strategy goal 20% or $40,000
> Total return $52,000 or 10.4%
>
> TO BE CONTINUED
>
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