Jump to content

Purchasing LEAPS (calls) deep ITM to leverage your position. Thoughts?


Value_Added
 Share

Recommended Posts

Hey all,

 

I wanted to get others thoughts on boosting a position into a company by purchasing deep ITM LEAPS via calls.  I won’t name any underlying stocks, instead will only lay out the strategy to get opinions on it.  This is a long term investment strategy with intent to keep the company for the long haul assuming the story doesn’t change.  I know options can be risky but this seems as though it would be low downside with large upside considering the research and analysis has been completed and it is at a price in which you’re happy to own the stock and has a built in margin of safety.

 

I already have a position in the underlying company which has been created via direct purchase of the stock, and an exercised PUT option.  It is 5% of my portfolio and I want to make it 10%.  For the remaining amount to meet the 10%, I was considering the strategy mentioned above and here is an example of how the numbers would break down.

 

For simplicity, lets assume stock price is $100/share which also happens to be a discount to the intrinsic value.  I would purchase a call option which would be deep ITM for about 24 months targeting a high delta and the adjusted basis would equal approximately the current share price.  In this case, lets assume we’re purchasing a call contract expiring June ‘23 with the strike price at $50 and costs approximately $55.  The adjusted basis after taking ownership of the shares 2 years from now would be $105 per share (assuming the price is above the strike).

 

Based on the above, those 100 shares would cost only $5,500 versus $10,000 and effectively acts as 2 to 1 leverage.  

 

This strategy as mentioned earlier, does carry the risk of losing the cost of the option entirely - in this example it would be $5500.  This would only be implemented on a company who is already at a price in which I’m willing to add it to my portfolio and with a built in margin of safety (based on my analysis).  

 

What are your thoughts on this and have others used this strategy before?  If so, were you able to use it successfully.

 

Thanks

Link to comment
Share on other sites

Ive done this for ages and the only thing I'd add is that you dont want to be 50% ITM. More like 20-30%. The point being to limit your losses. If you're even 10% off over 2 years...being that wrong for that long, probably means you're wrong. Obviously 10-20% short term is just a fluctuation. But I've found thats the long term sweet spot. I did this at the beginning of the year when BRK was at $230. Bought $175 LEAP calls. Same on MSFT. Bought $150s when the stock was at $210. Too far OTM is a gamble, too far ITM is a waste of capital and subjects you to bigger losses. Anyone telling you that losses are bigger with options just doesnt understand them. If you want to buy $100k worth of a $50 stock, theres plenty of ways to do it. But the most appropriate method would be to buy 20 ITM LEAPs with a ~$40 strike. If you're not wrong, just early, maybe the shares pullback 20%, in which case you can crush the trade by loading up on the same strike for only $5 or so(yea your downside is even less because of time value, ie @$50 the $40 call might be $12, but after a $10 decline the option won't be worth 2 it'll be worth probably $5). If youre dead wrong, well then you're shit out of luck. But anyone worried about a 100% loss on options is an idiot. I'd rather take a 100% loss on $20k worth of options than a 30% loss on $100k of common stock. Even though both represent the same underlying number of shares.

Link to comment
Share on other sites

Posted (edited)
39 minutes ago, Gregmal said:

Ive done this for ages and the only thing I'd add is that you dont want to be 50% ITM. More like 20-30%. The point being to limit your losses. If you're even 10% off over 2 years...being that wrong for that long, probably means you're wrong. Obviously 10-20% short term is just a fluctuation. But I've found thats the long term sweet spot. I did this at the beginning of the year when BRK was at $230. Bought $175 LEAP calls. Same on MSFT. Bought $150s when the stock was at $210. Too far OTM is a gamble, too far ITM is a waste of capital and subjects you to bigger losses. Anyone telling you that losses are bigger with options just doesnt understand them. If you want to buy $100k worth of a $50 stock, theres plenty of ways to do it. But the most appropriate method would be to buy 20 ITM LEAPs with a ~$40 strike. If you're not wrong, just early, maybe the shares pullback 20%, in which case you can crush the trade by loading up on the same strike for only $5 or so(yea your downside is even less because of time value, ie @$50 the $40 call might be $12, but after a $10 decline the option won't be worth 2 it'll be worth probably $5). If youre dead wrong, well then you're shit out of luck. But anyone worried about a 100% loss on options is an idiot. I'd rather take a 100% loss on $20k worth of options than a 30% loss on $100k of common stock. Even though both represent the same underlying number of shares.


I don’t typically like using the current market sentiment as a condition of buying/not buying a good business but the reason I was considering purchasing the call option 50% ITM was because of a potential correction in which seemingly nothing is safe from a large drop even if you’re right about your thesis.  I’m very happy owning the stock at the current price but would like to leverage my capital a bit which is why I’m considering this strategy.  I understand what you mean by potentially being a larger loss by going further ITM if you are wrong, but do you not see this as protecting yourself from the current market environment we are in?  It would take more capital yes, but is the added protection worth it when Mr Market could have a violent mood swing?

 

Please don’t think I am arguing your statements, I simply want to gain a full understanding of the potential outcomes as my ultimate goal is to own the stock after the option expires and the deeper ITM seems like more margin of safety to protect against Mr. Market.

 

Thanks for the info!

 

 

Edited by Value_Added
Link to comment
Share on other sites

I'd just give my personal approach and that is:

 

1) ANYTIME you are looking to add leverage or trade options you are making a bit of a timing call. If you think, or even whiff that a big correction is around the corner dont do it.

2) While I hear a lot from folks that you cant time the market or that 50% corrections happen more often than you think...this is definitely wrong on both accounts. Good, quality names dont go down 50% all that often and when they do, they snap back pretty quickly so a LEAP should protect you. 

3) Unless YOU are wrong. The banks didnt come back right away after the GFC because they weren't good companies. Whereas, just as an example, in 2016 or so I was long some C $40 LEAPS when the shares were at $52 or something. Stock got walloped on a correction(went to like 36-37 IIRC), my rule of thumb with this approach is when ITM becomes OTM because of a correction, back up the truck. I did and bought much more of the $40 strike as the shares went under $40. At maturity the stock was in the $60s. An example of this not working was Macys. I bought $30s when the shares were at $36 and well, it wasn't a quality company like I thought and it deserved to go down and the $30 strike saved me a good bit of losses. 

 

So I would just reiterate what I said in the first post. You are making a timing call. You dont want that much tied up. 10-20% short term is a fluctuation. 50% is not. If the 50% is macro inspired generally it doesnt last unless the company is effected, and if the company is effected, in that case, you were wrong.

 

Link to comment
Share on other sites

What are your thoughts on this and have others used this strategy before?

 

I'm not an expert on option strategies.

 

But sometimes you can accomplish the exact same thing less expensively.  Buy the stock on margin (at your target ITM strike) + buy a LEAP put at your strike price.  

 

But like I said - I don't really dabble in options. 

 

wabuffo

 

 

 

 

Link to comment
Share on other sites

5 hours ago, Value_Added said:


I don’t typically like using the current market sentiment as a condition of buying/not buying a good business but the reason I was considering purchasing the call option 50% ITM was because of a potential correction in which seemingly nothing is safe from a large drop even if you’re right about your thesis.  I’m very happy owning the stock at the current price but would like to leverage my capital a bit which is why I’m considering this strategy.  I understand what you mean by potentially being a larger loss by going further ITM if you are wrong, but do you not see this as protecting yourself from the current market environment we are in?  It would take more capital yes, but is the added protection worth it when Mr Market could have a violent mood swing?

 

Please don’t think I am arguing your statements, I simply want to gain a full understanding of the potential outcomes as my ultimate goal is to own the stock after the option expires and the deeper ITM seems like more margin of safety to protect against Mr. Market.

 

Thanks for the info!

 

 

 

The more concerned you are about a market correction, theoretically the less ITM you should be buying the call option (i.e. the higher the strike). With the higher strike calls, you are paying a higher "insurance" premium, but you are more protected for the same notional exposure. The lower strike calls give you less leverage and save you insurance premium cost. In the extreme case, a call option with a $0 strike is the same as owning the stock.

 

Another way to think about it: When you buy a call option, you're betting on high volatility and a high stock price. Higher strike calls are more of a bet on the former while lower strike calls are more of a bet on the latter.

Link to comment
Share on other sites

I've done this a few times, generally on quality businesses I thought were trading too cheaply where I was willing to buy the shares but wanted some leverage. 

 

Personally, I find taking the leverage focuses my due diligence, and my success rate has been very, very high. I would note that basically every time I've done this I've regretted not buying some deeply OTM options to go with the position as a bit of a kicker. 

 

So I've made it a heuristic that any time I'm buying ITM calls for leverage I should buy at least a few OTM calls as well. I've only had one position where I felt that way about it since I made that decision, (Costco $220 Jan 2023 earlier this year) and I bought OTM as well ($400 Jan 2023, which were quite OTM at the time). 

 

Just another perspective. Obviously you still need to get the timing right here, and going OTM increases the risk of a zero on a portion of the trade. But it makes the upside quite a bit more meaningful (on a percentage basis) if you're right. 

Link to comment
Share on other sites

3 hours ago, bizaro86 said:

So I've made it a heuristic that any time I'm buying ITM calls for leverage I should buy at least a few OTM calls as well.

 

Yeah, this is a form of diversification that reduces the prevalence of extreme outcomes compared to just putting it all in one strike.

Link to comment
Share on other sites

1 hour ago, IceCreamMan said:

 

Yeah, this is a form of diversification that reduces the prevalence of extreme outcomes compared to just putting it all in one strike.

 

Indeed. The OTM calls are way better in extreme outcomes (bigger % upside if it runs, and lower absolute loss per share if it drops) but much worse in a "flatish" scenario, where the ITM will be fine but the OTM is a 100% loss.

Link to comment
Share on other sites

3 minutes ago, Ross812 said:

It really comes down to what is on sale. If the vix is low options are on sale. After a crash, interest rates dive and you should be using margin.

 

Margin is fine if the event path is all the draw downs since GFC.  If you go into margin sometimes in 2008 because vol is high and expensive, you probably would have gone broke in early 2009.  If you suck it up and buy LEAPs and pay up for the leverage on leverage, you maybe wiped out on the call premium.  But your other non-margined assets should be fine.  I view it as non-recourse debt.  The market gods can take away my premium and ITM value, but "no mas."  Margin introduces portfolio risk and could force sell your entire portfolio at exactly the wrong time.  I guarantee you, your mind will be fucked when that happens.  

 

Everyone has a plan, but no one can really take a punch from Mike Tyson. 

Link to comment
Share on other sites

12 hours ago, BG2008 said:

 

Margin is fine if the event path is all the draw downs since GFC.  If you go into margin sometimes in 2008 because vol is high and expensive, you probably would have gone broke in early 2009.  If you suck it up and buy LEAPs and pay up for the leverage on leverage, you maybe wiped out on the call premium.  But your other non-margined assets should be fine.  I view it as non-recourse debt.  The market gods can take away my premium and ITM value, but "no mas."  Margin introduces portfolio risk and could force sell your entire portfolio at exactly the wrong time.  I guarantee you, your mind will be fucked when that happens.  

 

Everyone has a plan, but no one can really take a punch from Mike Tyson. 

It depends how you are using margin I suppose. I run a diversified portfolio targeting 1.25x leverage. The leverage comes from options, futures, and/or margin. 2008 and 2020 didn't result in any margin calls. I agree with you if you are running a concentrated portfolio of 5-10 companies and how much leverage you are targeting. In my opinion, using leverage at all without using cash, options, bonds, or gold as insurance is irresponsible. The risk profile of having $100k and buying 4 $280 2023 LEAPs on BRK.B for $12.5K and leaving $87.5k in cash is different from buying 400 shares of BRK.B and holding $12k on margin.  

 

 

Link to comment
Share on other sites

14 minutes ago, Ross812 said:

It depends how you are using margin I suppose. I run a diversified portfolio targeting 1.25x leverage. The leverage comes from options, futures, and/or margin. 2008 and 2020 didn't result in any margin calls. I agree with you if you are running a concentrated portfolio of 5-10 companies and how much leverage you are targeting. In my opinion, using leverage at all without using cash, options, bonds, or gold as insurance is irresponsible. The risk profile of having $100k and buying 4 $280 2023 LEAPs on BRK.B for $12.5K and leaving $87.5k in cash is different from buying 400 shares of BRK.B and holding $12k on margin.  

 

 

 

Yeah, I tend to own a lot more concentrated less liquid names like FRPH.  In a crisis, they don't function like AAPL and I can easily get margin called even if the gross exposure is only 125%.  

Link to comment
Share on other sites

22 minutes ago, Ross812 said:

It depends how you are using margin I suppose. I run a diversified portfolio targeting 1.25x leverage. The leverage comes from options, futures, and/or margin. 2008 and 2020 didn't result in any margin calls. I agree with you if you are running a concentrated portfolio of 5-10 companies and how much leverage you are targeting. In my opinion, using leverage at all without using cash, options, bonds, or gold as insurance is irresponsible. The risk profile of having $100k and buying 4 $280 2023 LEAPs on BRK.B for $12.5K and leaving $87.5k in cash is different from buying 400 shares of BRK.B and holding $12k on margin.  

 

 

 

Btw, can you actually give a crash course on how margin works at a broker at IBKR.  I occasionally may go 101-102% gross. It's really a function of not wanting to sell a position and wanting to buy some stuff.  I see excess equity.  I see notice on margin % for certain securities, etc.  I can really use a crash course on the terms etc.  I just have never considered using margin.  I have zero credit card debt and the stuff that I owe are 30 year fixed rate with 3 handles.   

Link to comment
Share on other sites

Yea I think its wise to be cautious but boy oh boy do I feel like there are A LOT of misconceptions around margin. Bright eyed and bushy tailed I entered the sales end of the financial world heeding every preconceived notion about borrowing/debt/risk. Dont borrow ever. Margin is dangerous. The whole 9. Through that same sales job I got thrown into the world of "borrow/risk on"...So Ive been on both sides and thrown into the fire navigating the pitfalls and unpleasant surprises...and the truth for me is that(again, speaking to sophisticated investors) its very, very hard to blow yourself up with margin if you do it properly. I actually think the IB parameters are great. You cant really do risky things with small cap or illiquid stuff. Same time you have a lot of leeway with the larger and liquid stuff. But the bottom line is that your biggest risks in terms of blowing up are shorting calls, and massively concentrated positions. Everything else is manageable. If you survived March 2020 IMO you can survive anything(again speaking broadly to sophisticated investors). The whole market doesnt just gap down 25% overnight and your broker sends auto message "hey you're blown up!". March 2020 is the closest thing we've had to that and still, there was plenty of time to reposition/hedge/adjust as things unfolded. If you're using margin there should always be sources of liquidity or places to pull liquidity from. Its why I like spacs. But at 1.2-1.4x I dont think any competent person should have issues. Someone always says, "things can go down 50%"....and sure they can....but not overnight and as its happening you should be adjusting and reassessing your risk profile. Problem solved. 

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...