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Strategies

There are many different strategies that an investor can use to capture index appreciation over long periods of time using derivatives (i.e. futures and options). Here we list some of the most useful ones that we've found:

Rolling LEAP Call Options

Rolling LEAP Call Options is a deceptively complex but very effective long-term leveraged investment strategy. To implement it, an investor purchases a portfolio of two-year LEAP call options on various securities. Then one year later, the investor sells the options and buys new ones with an expiration date one year into the future. This is repeated for years or even decades.

If the underlying index appreciates at a rate higher than the cost of capital and hedging costs then the call options gain in value. Given typical rates of index appreciation, long-term annual returns in the high teens or low twenties is expected. Of course on a daily or weekly basis the value of the investment can fluctuate considerably. Cash can also be withdrawn from the portfolio by raising the strike prices.

The main benefit of this strategy is that the investor can predict the roll forward costs of the various options to some degree, which creates a high level of certainty in cash outflows. These cash outflows can be matched to current income.

Rolling LEAP Options in Investopedia

Diagonal Call Spread

To implement the strategy, an investor combines a long in-the-money call option and a short at-the-money option. The expiration date of the long option is later than that of the short option, for example the long option may be sixty-days and the short-option is thirty-days. Many different expiration combinations are possible, and the position can be held to expiry or exited early, even one leg at a time.

Ideally the volatility skew between the two options is minimal, and the cost of the short option helps fund the cost of the long option and then expires worthless. However, there is also the case in which the short option needs to be bought back at a premium and then the long option loses value. This is called the "deadly" diagonal and can be mitigated by effectively using repetition.

Diagonal Call Spread in Options Trader (Nov 2007 issue, available for purchase)

Calendar Call/Put Spreads

The Calendar call and put spreads are highly leveraged positions that are only possible on highly liquid indexes with low transaction costs. Like Diagonal call spreads, calendar spreads can deliver extremely high returns in a short period of time, but have very wide return distributions are best used in repeated strategies.

To implement a calendar call strategy, an investor combines a long at-the-money call with a short at-the-money or out-of-the-money call on the same index. The only difference is the expiration dates: the long option expires later. The objective is that the short option helps to fund the long option and then expires worthless, but at that point the market price is still close enough to the strike price to make the long option valuable, which is then sold.

Calendar spreads are risky investments with razor-thin margins that can gain and lose value rapidly due to changes in index volatility and/or rapid price movements and are best used in conjunction with other indexing strategies.

Calendar Call/Put Spreads in Options Trader (Feb 2008 issue, available for purchase)

Speedbump Hedge

A speedbump hedge is a cost-effective hedging strategy that can be used to complement both index future and call option portfolios. Like most hedges it has a negative expected value but can provide considerable protection in situations in which the investor is highly leveraged and the index declines sharply.

The position is implemented by purchasing a bear put spread in which the long put option is about ten percent below the market price and the short put option is about ten percent to fifteen below that. Both are typically LEAP options and the short option helps fund the cost of the long option. The volatility skew is also favorable and helps reduce the cost.

Speedbump Hedge in Investopedia

Futures Covered Call

Short call options can be combined with index futures to create highly leveraged covered call portfolios. An unleveraged covered call portfolio will often, but not always, have higher returns and lower standard deviations then the underlying index due to the premium between implied and historic volatility.

When max leverage is applied, the returns can be extremely high, for example 20-30% a month but with high standard deviations. The position is best used as a repeated strategy and performs well for longer holding periods. Still, depending upon the leverage ratio, hedging positions may be required to avoid catastrophic loss.