Buying long term SPY call options (in the money leaps) instead of SPY

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verythankful
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Buying long term SPY call options (in the money leaps) instead of SPY

Post by verythankful »

Team,
I have been thinking of buying deep in the money SPY calls ( leaps 2yr+ expiry). After one year roll over them to next 2yr leap. Continue next 20 yrs. Stop rolling 2 years before retirement. To avoid tax drag, executing it in roth or tIRA.
Some concerns: high bid ask spreads, no dividend.

Say one has 5-10 of years expenses in treasuries or bonds and willing to bear volatility with long term objective. What are some concerns you see with this strategy instead of just buying SPY? or why would you not do it?


Comfortable with current AA ratio in 401k, taxable etc.
11/21/2020: Updated to make content more generic
Last edited by verythankful on Sat Nov 21, 2020 7:15 pm, edited 2 times in total.
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Steve Reading
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Re: Planning DITM leaps in Roth, feedback pls?

Post by Steve Reading »

verythankful wrote: Sat Mar 07, 2020 11:51 am I have been thinking of buying deep in the money SPY leaps ( 2yr+ expiry). After one year roll over them to next 2yr leap.
Why wouldn't you buy them with a 1 yr expiration then? The less you roll them, the lower the possibility of a bad roll due to volatility. Or the reverse: if you buy with 2yr expiration, why not hold until close to maturity? This also minimizes the number of spreads you eat over the years.
verythankful wrote: Sat Mar 07, 2020 11:51 am Some concerns: high bid ask spreads, no dividend, no TLH in Roth,
I don't need this money, may be will gift it in the end.
Comfortable with current AA ratio in 401k, taxable etc.
Would appreciate your feedback.
You should account for the bid-ask spread. The lack of dividends is already factored in the price. You don't get to TLH but you also don't pay capital gains whenever you roll. Since the market is most likely to be positive than negative, the Roth is superior to taxable.

It's unclear why you want to leverage the Roth. But to the extent you're sure you want to, an SPY call LEAP strike 200 with expiration Dec 2022 is currently offering ~3:1 leverage at an implied borrowing rate of about 3.9%, provided you hold until close to maturity (once again, if you roll before, it might be better or worse). This accounts for the spread, lack of dividends and no taxes. This has no possibility of margin call and even has some downside protection (can't lose more than the investment, which would occur if the market tanks ~33%).

Evidently bonds are yielding much less so it would make little sense to buy this if you hold bonds. But if you're 100% stocks and looking for more exposure, I think this is attractive.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Topic Author
verythankful
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Re: Planning DITM leaps in Roth, feedback pls?

Post by verythankful »

Thanks for reply 305pelusa.
The motivation to sell much before expiry date is to minimize effect of time premium. It works also for 1yr expiry+ roll six months before expiry. Usually the time premium effects kick-in at steeper rate from 6 months before expiry and very high in last month.
I am researching on leverage and borrow rate you mentioned, I will revert on that.
Topic Author
verythankful
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Re: SPY call options DITM leaps roll in Roth, feedback pls?

Post by verythankful »

Regarding motivation to leverage Roth: I won't be able to buy that much SPY index with Roth balance. So leverage using option leaps is one way to achieve it. Tax drag of doing this in taxable is significant.
Caduceus
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Re: SPY call options DITM leaps roll in Roth, feedback pls?

Post by Caduceus »

I wouldn't do it myself, not because I have any objections to trying to leverage your Roth using DITM leaps, but because I'd only be tempted to do something like that if the current level of the SPY was truly compelling.

There are some companies that I think are trading at least 50% below fair value, and if they are brought even lower together with the general market as a result of this coronavirus event, I will seriously consider buying DITM leaps on them with a small part of my portfolio, but that's because I actually love their current valuations. I don't like current SPY valuations, and can't see myself being tempted to do something like that.
Topic Author
verythankful
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Re: SPY call options DITM leaps roll in Roth, feedback pls?

Post by verythankful »

Thanks Caduceus,
Doing it on individual stock would be risky and difficult to implement barring few active stocks.
If we expect market to go up in long term this strategy should work on SPY.
Topic Author
verythankful
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Re: SPY call options DITM leaps roll in Roth, feedback pls?

Post by verythankful »

SPX maybe better choice, barring high investment threshold
bling
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Re: Planning DITM leaps in Roth, feedback pls?

Post by bling »

Steve Reading wrote: Sat Mar 07, 2020 12:47 pm Why wouldn't you buy them with a 1 yr expiration then? The less you roll them, the lower the possibility of a bad roll due to volatility. Or the reverse: if you buy with 2yr expiration, why not hold until close to maturity? This also minimizes the number of spreads you eat over the years.
bumping old thread, since i'm considering doing something similar.

since this is a Roth with no tax consequences, why do we need to trade LEAPs? wouldn't it be better to trade shorter term options for the much better spreads due to increased liquidity? you roll a lot more often, but you will also lose a lot less to the spread.
EfficientInvestor
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Re: Planning DITM leaps in Roth, feedback pls?

Post by EfficientInvestor »

bling wrote: Sun Nov 08, 2020 8:24 am
Steve Reading wrote: Sat Mar 07, 2020 12:47 pm Why wouldn't you buy them with a 1 yr expiration then? The less you roll them, the lower the possibility of a bad roll due to volatility. Or the reverse: if you buy with 2yr expiration, why not hold until close to maturity? This also minimizes the number of spreads you eat over the years.
bumping old thread, since i'm considering doing something similar.

since this is a Roth with no tax consequences, why do we need to trade LEAPs? wouldn't it be better to trade shorter term options for the much better spreads due to increased liquidity? you roll a lot more often, but you will also lose a lot less to the spread.
The time premium (theta) decays much faster on shorter term options. When you go further out in time, the theta decay decreases. However, as you know, the bid/ask spread increases. So it’s a trade off you have to consider. I find that it is better to use longer term options and side with the lower theta decay. You just need to be patient when entering the position in order to get the best fill possible.

For example...let’s assume we want to buy a 280 call on SPY. Regardless of how far out in time we go, the intrinsic value is the same. Therefore, any difference in price is due to extrinsic value. The difference between the mid prices of the Dec 2020 option and Dec 2021 option is currently $8.68. The difference between the mid prices of the Dec 2021 and Dec 2022 is $5.50. All else being equal and assuming you could get fills approximately near the mid price, this means you would pay $3.18 per year more in premium for holding the nearer term option. The current spread on the Dec 2022 option is $1.72. If we could buy/sell the option at the exact mid-price, then there would be no slippage. In reality, we would have to buy it somewhere between the mid price and the ask. Even if we bought it at the ask, which is the worst case scenario, we would be $0.86 worse than the mid price. In reality, based on my experience, you could probably get that option filled for somewhere within $0.20 of the mid price. In comparing this slippage to the difference in premium decays, I would much rather deal with the bid/ask slippage.
EfficientInvestor
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Re: Planning DITM leaps in Roth, feedback pls?

Post by EfficientInvestor »

bling wrote: Sun Nov 08, 2020 8:24 am
Steve Reading wrote: Sat Mar 07, 2020 12:47 pm Why wouldn't you buy them with a 1 yr expiration then? The less you roll them, the lower the possibility of a bad roll due to volatility. Or the reverse: if you buy with 2yr expiration, why not hold until close to maturity? This also minimizes the number of spreads you eat over the years.
bumping old thread, since i'm considering doing something similar.

since this is a Roth with no tax consequences, why do we need to trade LEAPs? wouldn't it be better to trade shorter term options for the much better spreads due to increased liquidity? you roll a lot more often, but you will also lose a lot less to the spread.
I bought another SPY LEAP today and was able to test out my assumption on the amount of slippage in the bid/ask spread. I bought the Dec 2022 call at 300 for 77.71. I started my bid well below the mid and then increased it incrementally until it got filled. Right after it got filled, the mid price went back to around 77.41. So you could say there was about .30 slippage on the trade.

Another alternative you could consider is to decouple the leverage from the insurance. Instead of buying an ITM call, buy 2 /MES futures contracts and then hedge it with 1 put option on SPY. 2 /MES contracts has similar nominal value to 1 SPY contract. The reason for doing this is the put options have much tighter spreads than the call options 2 years out in time. I just bought a Dec 2022 put at 300 for 24.95 when the mid price was 24.91. This is the same expiration and strike as the call mentioned above, but it didn't have much slippage at all. The downside of doing this is that you have to roll futures quarterly in addition to rolling the put annually. So there is a little slippage with the futures roll, but it's almost negligible given the liquidity of those markets.
bling
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Re: Planning DITM leaps in Roth, feedback pls?

Post by bling »

EfficientInvestor wrote: Mon Nov 09, 2020 2:37 pm I bought another SPY LEAP today and was able to test out my assumption on the amount of slippage in the bid/ask spread. I bought the Dec 2022 call at 300 for 77.71. I started my bid well below the mid and then increased it incrementally until it got filled. Right after it got filled, the mid price went back to around 77.41. So you could say there was about .30 slippage on the trade.
maybe, maybe not.... with the market moving so fast sometimes i feel trying to get in at the right price ends up costing you money because the price moves against you.

i also bought today, and did something similar. i put in the mid-price. no fill. replaced it with a slightly higher mid-price. no fill. replaced it one last time, between the mid and the ask. it was filled immediately with a price improvement, which was cool (this is with fidelity). i ended up buying a dec 22 call @275 strike filled at $98.85.

of course, the very first time i buy a DITM call i lose money as the market takes a 2% dive just before market close! at my strike that works out to around 3x leverage! ouch.

another thing that's really annoying is that this option has completely messed up all my spreadsheets.
Topic Author
verythankful
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Joined: Sat Nov 16, 2019 9:20 pm

Re: Planning DITM leaps in Roth, feedback pls?

Post by verythankful »

EfficientInvestor wrote: Sun Nov 08, 2020 12:45 pm
bling wrote: Sun Nov 08, 2020 8:24 am
Steve Reading wrote: Sat Mar 07, 2020 12:47 pm Why wouldn't you buy them with a 1 yr expiration then? The less you roll them, the lower the possibility of a bad roll due to volatility. Or the reverse: if you buy with 2yr expiration, why not hold until close to maturity? This also minimizes the number of spreads you eat over the years.
bumping old thread, since i'm considering doing something similar.

since this is a Roth with no tax consequences, why do we need to trade LEAPs? wouldn't it be better to trade shorter term options for the much better spreads due to increased liquidity? you roll a lot more often, but you will also lose a lot less to the spread.
The time premium (theta) decays much faster on shorter term options. When you go further out in time, the theta decay decreases. However, as you know, the bid/ask spread increases. So it’s a trade off you have to consider. I find that it is better to use longer term options and side with the lower theta decay. You just need to be patient when entering the position in order to get the best fill possible.

For example...let’s assume we want to buy a 280 call on SPY. Regardless of how far out in time we go, the intrinsic value is the same. Therefore, any difference in price is due to extrinsic value. The difference between the mid prices of the Dec 2020 option and Dec 2021 option is currently $8.68. The difference between the mid prices of the Dec 2021 and Dec 2022 is $5.50. All else being equal and assuming you could get fills approximately near the mid price, this means you would pay $3.18 per year more in premium for holding the nearer term option. The current spread on the Dec 2022 option is $1.72. If we could buy/sell the option at the exact mid-price, then there would be no slippage. In reality, we would have to buy it somewhere between the mid price and the ask. Even if we bought it at the ask, which is the worst case scenario, we would be $0.86 worse than the mid price. In reality, based on my experience, you could probably get that option filled for somewhere within $0.20 of the mid price. In comparing this slippage to the difference in premium decays, I would much rather deal with the bid/ask slippage.
Thanks @EfficientInvestor. in your opinion, does it make sense to not go all the way to max available leap but try something in the range of 1-2yrs. Trying to find optimal between going long and avoiding bid/ask slippage..
Topic Author
verythankful
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Re: Planning DITM leaps in Roth, feedback pls?

Post by verythankful »

bling wrote: Mon Nov 09, 2020 7:42 pm
EfficientInvestor wrote: Mon Nov 09, 2020 2:37 pm I bought another SPY LEAP today and was able to test out my assumption on the amount of slippage in the bid/ask spread. I bought the Dec 2022 call at 300 for 77.71. I started my bid well below the mid and then increased it incrementally until it got filled. Right after it got filled, the mid price went back to around 77.41. So you could say there was about .30 slippage on the trade.
maybe, maybe not.... with the market moving so fast sometimes i feel trying to get in at the right price ends up costing you money because the price moves against you.

i also bought today, and did something similar. i put in the mid-price. no fill. replaced it with a slightly higher mid-price. no fill. replaced it one last time, between the mid and the ask. it was filled immediately with a price improvement, which was cool (this is with fidelity). i ended up buying a dec 22 call @275 strike filled at $98.85.

of course, the very first time i buy a DITM call i lose money as the market takes a 2% dive just before market close! at my strike that works out to around 3x leverage! ouch.

another thing that's really annoying is that this option has completely messed up all my spreadsheets.
Hi @bling, what is your strategy for the roll (if i may ask)? will you just follow the method of roll before the time values start decreasing and continue?
bling
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Re: Planning DITM leaps in Roth, feedback pls?

Post by bling »

verythankful wrote: Sat Nov 21, 2020 4:34 pm Hi @bling, what is your strategy for the roll (if i may ask)? will you just follow the method of roll before the time values start decreasing and continue?
not sure yet! :D

this is the first time i've bought DITM options so i'm learning/experimenting as i go. so this is either going to be a very expensive lesson or my roth will grow at a much faster pace.

i currently hold multiple DITM call options, bought within days of each other holding SPY, EFA, EEM at market weight proportions. some things i've learned already:

1) i got overconfident in fidelity's price improvement. the next trade i did, i put it in at the ask, and it was filled at that price. so it was a rather costly lesson once you multiply by 100. i will always place orders at the mid price moving forward.

2) volume is extremely low. i might have been the only person who bought a contract for my strike/expiry on that day. so the price might not be efficiently priced and i'm at the mercy of whatever price market makers are giving me.

3) on a tangent to #2, deep ITM call options with high delta in theory should follow the movement in the underlying. it doesn't on a day to day basis. fidelity shows this little warning on the positions screen that indicates whether a security has been priced intraday. mutual funds for example will have this warning as they are priced after close. all of my options had the warning, meaning no one was trading them. if you load a price graph for an option you can also see how choppy it is due to missing data.

4) i'm not there yet, but it's inevitable that at some point i will need to rebalance due to regular market movements, and that could create a mess of trades to rebalance. at least i'm in a roth so all it means is losing to the spread getting in/out.

but to answer your original question, my plan right now is to roll with 6 months left, or abandon the experiment and go back to index funds.
Topic Author
verythankful
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Re: Planning DITM leaps in Roth, feedback pls?

Post by verythankful »

bling wrote: Sat Nov 21, 2020 5:17 pm
verythankful wrote: Sat Nov 21, 2020 4:34 pm Hi @bling, what is your strategy for the roll (if i may ask)? will you just follow the method of roll before the time values start decreasing and continue?
not sure yet! :D

this is the first time i've bought DITM options so i'm learning/experimenting as i go. so this is either going to be a very expensive lesson or my roth will grow at a much faster pace.

i currently hold multiple DITM call options, bought within days of each other holding SPY, EFA, EEM at market weight proportions. some things i've learned already:

1) i got overconfident in fidelity's price improvement. the next trade i did, i put it in at the ask, and it was filled at that price. so it was a rather costly lesson once you multiply by 100. i will always place orders at the mid price moving forward.

2) volume is extremely low. i might have been the only person who bought a contract for my strike/expiry on that day. so the price might not be efficiently priced and i'm at the mercy of whatever price market makers are giving me.

3) on a tangent to #2, deep ITM call options with high delta in theory should follow the movement in the underlying. it doesn't on a day to day basis. fidelity shows this little warning on the positions screen that indicates whether a security has been priced intraday. mutual funds for example will have this warning as they are priced after close. all of my options had the warning, meaning no one was trading them. if you load a price graph for an option you can also see how choppy it is due to missing data.

4) i'm not there yet, but it's inevitable that at some point i will need to rebalance due to regular market movements, and that could create a mess of trades to rebalance. at least i'm in a roth so all it means is losing to the spread getting in/out.

but to answer your original question, my plan right now is to roll with 6 months left, or abandon the experiment and go back to index funds.
Agree volume is low as we do deep in the money. However, on actively traded tickers (say SPY) the spread is not that bad. Especially with low interest rates. Additionally as market move up and the strike goes deeper in the money the leap price moves pretty much in sync with stock/etf.
Marseille07
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Re: Buying long term SPY call options (in the money leaps) instead of SPY

Post by Marseille07 »

Volume shouldn't matter as you're dealing with MMs as soon as you place your trade. A bigger question is if call options make more sense than simply holding SPY, with all the baggage you have to deal with that you otherwise don't have holding ETFs / MFs.
Topic Author
verythankful
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Re: Buying long term SPY call options (in the money leaps) instead of SPY

Post by verythankful »

Marseille07 wrote: Sat Nov 21, 2020 7:33 pm Volume shouldn't matter as you're dealing with MMs as soon as you place your trade. A bigger question is if call options make more sense than simply holding SPY, with all the baggage you have to deal with that you otherwise don't have holding ETFs / MFs.
Definitely there is additional work involved, rolling trades once or twice every year. But if our belief is that markets go up in long run, consistently rolling options will reward with higher returns..
bling
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Re: Buying long term SPY call options (in the money leaps) instead of SPY

Post by bling »

Marseille07 wrote: Sat Nov 21, 2020 7:33 pm Volume shouldn't matter as you're dealing with MMs as soon as you place your trade. A bigger question is if call options make more sense than simply holding SPY, with all the baggage you have to deal with that you otherwise don't have holding ETFs / MFs.
the point of using deep call options is for leverage. if you don't intend on magnifying your gains (and losses), there's no point in using them. so really the question is whether this is the best way to obtain leverage. the other options are futures, borrowing on margin, or leveraged ETFs/funds. since i'm in a roth, that means no margin. since i'm at fidelity, that means no futures. so that leaves me with options and/or leveraged funds.
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