Guest Post From Karl

A frequent reader of this blog has asked that I post his MFI strategy.  It is a  derivative of one I have mentioned a couple times on here, using options as opposed to buying the stock directly.  Clearly, when the market is going up, this will be a superior approach.  However, it should have greater volatility.  As he buys positions that are deep in the money, the risk of a position going to zero in minimized.  One issue I have seen with an approach like this is many options are pretty ill-liquid.  (I have tried to embed a link to his PDF at the bottom). Here is his post:

Marsh,

I decided to try a MFI portfolio utilizing LEAP options instead of buying the underlying securities.  LEAPS (Long-term Equity AnticiPation) are regular options in all respects except that they are available for a year or more out. Most options are for 3, 6, and 9 months. There are about 2500 LEAP options available.  From my MFI list of 30 stocks (>$500 million) I found 17 that have LEAPs. On October 28, 2013 I bought deep in the money calls on these stocks.  You want in the money calls to preserve capital and assure a relatively high delta (a $1.00 change in stock price giving a $0.80 change in option price, or better).  As you can see, I bought January 17, 2015 options (\15A17\) and tried to get about $2000 to $3000 in contracts. Each call, as usual, represents 100 share except for Apple which has a 10 share lot available for smaller investors like me. Google and a few other high price stocks have this 10 share version available.  An example from the top table for Coach (COH) shows that I bought 2 calls (200 share) for $11.30 and an entry cost of $2,260. The call I bought is at a strike price of $40 and is 80.2% of the stock quote on that day $49.89.  On Dec 15 these calls were priced at $17.10 for a profit of $1,160 (+51.33%). You can also see that the underlying stock has gone from $49.89 to $55.72 in the lower table.  I must have had a senior moment when I bought the PBI call, since I only bought one call and should have bought about 4 at $5.39. Oh well.

            The important thing is that the LEAPS have a 17% gain (+$6,930) while the underlying securities have increased 4.72%. I have not shown it in these tables, but in order to have made the same profit using stocks in the same proportions one would have to have invested $130,928 instead of the $42,278 in the call options. Another consideration is that the calls become worthless if the stock price declines to the strike price, i.e. about a 20% decline. I think I am secure against that and would rather lose 10% on the options than 10% of $130,000.  Remember these are standard calls, we are not writing (selling) these options against existing positions (covered calls) like the strategy of Trader et al.

            It looks like this is an interesting strategy that so far is working. I plan to continue to follow it for the year.  I would like your opinion and those of the folks on you blog. Please let me know if you have any questions.

            Cheers, Karl

https://drive.google.com/file/d/0B3E8wzubbADcOTBFdl84UzN4dzA/edit?usp=sharing