DLS-PAPER TRADE #3
At risk is the value of the leap = $25,696 out of $200,000 or 12.85% rather than 100% if we bought IWM in the buy-hold portfolio
We have $174,304 to put into the dls cash account. The purpose of the dls cash account is two-fold
1) to roll out our leaps at the proper time when new further out leaps are available
2) to purchase additional leap contracts when our minimum monthly income goal can not be met
I allocate 30% of that cash for rolling and 70% for purchasing additional leap contracts
ie.
rolling = 30% * $174,304 = $52,912
additional leap contracts = 70% * $174,304 = $122,012
Now we need to generate our monthly income by selling short calls.
What strike price for the short call?
I select the strike with the most time value.
What expiration for the short call? (revision of my original DLS Paper)
I go out to a 3 month expiration.
Let's look at the reasons for my revision. I have had people who initiated a dls strategy purchasing all desired leap contracts and sell near month short calls only to see a market correction. The percentage loss looks enormous and has scared people into closing the position and considering it a failure. A 10% drop in IWM would represent about a 25% drop in the value of our Jan12-50 strike leap.
Math: IWM at $69.56 with a 10% drop would be a $6.96 drop in value. Our Jan12-50 strike leap at $23.36 with a delta of 0.84 would drop about $6.96 * 0.84 = $5.84
Therefore, our leap would drop from $23.36 to ($23.36-$5.84) $17.52 or a 25% loss of market value.
If there is a correction, by going out to a 3 month expiration for our short calls and legging into full leap position over 3 months we purchase additional leaps at a progressively lower premium thereby dollar cost averaging into the position.
Another reason is the premiums of the short calls at 3 month expiration are much greater and affords us greater downside protection, often greater than 12%.
Another reason is that more often than not the premiums at 3 months will make the difference between our short call and leap strikes greater than our net debit (leap cost - short call income). This is important because even if we sell short call contracts equal to number of leap contracts we are guaranteed a profit. Even if assigned early or at expiration.
How many short call contracts to sell?
Based on above for the initial positions one could sell at a ratio of 10:10 and have more downside protection, often greater than 15%.
However, I will sell at a ratio equal to the delta of the leap. ie....8:10, leap delta is 0.84 so I roll down to 0.80.
That allows us to participate in an uptrend of the underlying while still giving us our monthly income goal.
So, let's look at our initial short call position.
11 leap contracts * 0.84 is 9.24 rolling down to 9 short call contracts
Aug10-70 strike call is $4.25 (100 dte)
Income generated is $4.25 * 900 = $3,825
Has our income goal been met? Remember this is 100 days to expiration so we need to adjust that $3,825 to see if it meets our monthly goal of $3,333. We can do this by taking the $3,825 * 90 days (3 months)/ 100 days to expiration = $3442.
Our monthly goal is met.
Before we move on let's look at our net debit (cost basis):
Leap cost = ($25,696)
Short call premium = $3,825
Net debit = ($21,871)
Cost basis per leap contract = ($21,871/1100) = ($19.88)
Remember, the difference in out strikes is $70 minus $50 or $20
That $20 is less than our net debit of $19.88. Therefore, even if assigned and even if we sold ratio of short call to leap of 11:11. We will not lose money.
--- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@...> wrote:
>
> 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:
> >
> > 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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