Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 7

Long-Term Returns Using Rolled LEAPS

The last chapter introduced the technique of rolling LEAPS call options in order to maintain permanent leverage on the index. Rolled LEAPS call options have predictable cash outflows, and this can reduce some of the risk involved in managing a leveraged portfolio, while still delivering high returns.

In this chapter, we analyze the returns of various sector- and index-based LEAPS portfolios using recent market data in order to further understand the behavior of these investments in different market conditions. Also, results are analyzed with and without rebalancing to determine the effect of that technique on the portfolio returns and draw some conclusions about the nature of leverage with a permanent hedge.

LEAPS call options can be used as the basis for a covered-call writing strategy, and we do this with two indexes to see the results. Selling calls can help pay for the interest and roll-forward costs, but definitely has an effect on the predictability of the cash flows, as will be seen.

STRIKE PRICE SELECTION

LEAPS call options can be viewed as composed of three distinct components: intrinsic value, interest costs, and a hedge. The intrinsic value is simply the difference between the current market price and the original strike price. The time value includes both the interest costs and the hedging costs. The interest costs can be backed out by using the cost of capital (prevailing interest rate minus dividends), and then the ...