Wednesday, February 27, 2013

Long/Short XLF and C

This post describes a strategy CCI uses to try to achieve an alternate investment returned.  It deploys
  • Leverage - by being long, longer term, deep ITM options (usually using LEAPS to replace being long a stock/ETF)
  • Hedging - by being short, nearer term, OTM options (basically, a rolling covered call strategy)
  • Pairs - these two options can be in the same underlying or in a pair of entities

This type of trade is bullish and profits when the underlying stock rises. Further, the LEAP is by its nature provides leverage to the position which means it will gain or lose more on a percentage basis as the underlying price moves around.  The obviously increases the potential reward and also the potential risk. To offset some of that risk, a nearer term call can be written against that position.  While this caps the gains it also reduces the cost/risk of the trade.

Explaining all the rationale for these positions can be somewhat involved. Over time, CCI  intends to develop a more overall, general description of this approach.  This post describes a position in-play this year. Hopefully, this example position can also be an effective way to illuminate the strategy.  Here is one of CCI's current positions using this strategy.

  • In early January, CCI bought the $10 Call that expires Jan of 15 (22  months from now) in the financial sector ETF (XLF).   CCI paid  $7.04/contract.  At the time XLF was trading around $17.00.  Hence that position theoretically provides 2.4 times leverage in the holding.   Perhaps that is best illustrated by the current trade prices. XLF  closed trading today at $17.62 a gain of 3.6%.  The final bid for the Jan 15 $10 call was $7.60 a gain of 8.0%. That is a demonstrated 2.2 times leverage.
  • While it is nice to have achieved that paper gain, it is important to note that the gain was only achieved because of the increased risk of the leverage.  To try to minimize that risk, CCI has sold calls against the position.  In many cases that could simply be a call in the same underlying stock/etf.  For example, selling the $18 Mar call in XLF.  In this case, as an alternative strategy CCI has been selling calls in Citigroup (C).  This paired stock was selected for several reasons including:
    • C and XLF are highly correlated, in fact C is about a 6% holding in this ETF.
    • In general, CCI feels the big banks may underperformed the rest of the financials sector.
    • XLF strikes are $1 wide which is 6% of the underlying price.  That large distance between strikes makes it challenging to find effective covered calls.   C has $1 wide strike as well but that is just 2%of the underlying and offers more choices.
    • Implied volatility in C's options is higher than XLFs.  That means C's options offer more premium when sold.  
  •  CCI has successfully sold and bought back options in C in January and February for a combined gain of   $.28/contract  That adds 4% to the returns of the amount at risk on the LEAPS, but does almost double the amount of cash required for the position.  Factoring in both returns and both capital requirements results in only bumping the total return from 8.0% to 8.5%.  However, perhaps more importantly this position acted as somewhat of a hedge if the LEAP had not gone positive
  • Today, CCI sold the March $44 call in C to try to add to this type of gain. 
Hopefully, that was illustrative of the approach and stay tuned for more examples, descriptions, and tracking of these type of positions.

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