Leverage & Strikes
Why choose a 60% strike rather than a 50% strike? Why not 70%? Or 80%? When should we roll up? I thought that I would go back to basics this week and go over choosing options and the leverage that gives us.
Leverage
I know that our ITM signal came last November when SPY was $440, but to make the calculations easier to follow let’s assume that we bought our options when it was trading at $400.
- 50% strike: $200
- 60% strike: $240
Now let’s ignore time value for the moment (we’ll come back to that later) and see how each of these performs.
- The $200 strike option costs $200 (how? $400 – $200)
- The $240 strike option costs $160 (How? $400 – $240)
Now let’s see our positions when SPY has gone up 25% and is now $500
- The $200 strike is now worth $300 (how? $500 – $200)
- The $240 strike is now worth $260 (how? $500 – $240)
Both options have gone up by the same amount ($100), as you would expect but when we compare it with the initial cost of the options we see the difference.
- The profit is the current price – initial price
- The profit % is the profit / initial price
The profit is the same in both cases, but the profit % is different. This gives us the outcome:
- The $200 strike has gone up 50% (how? $100 / $200)
- The $240 strike has gone up 62.5% (how? $100 / $160)
So, you can see that the 60% strike gives us more leverage than the 50% strike. We have a higher profit percentage.
Brilliant – let’s do 70% strike!
If 60% is good, why not 70%? That would give us an even bigger profit. If we bought at $120 then we would have a profit of 83%. Doesn’t that sound great? Why not an 80% strike? That would give us a profit of 125%, so much better! Let’s go for 90%! That’ll give us a 250% profit! Let’s go for . . .
Euphoria clouds your judgement
It is easy to get carried away like this but there are two things that you have to remember:
Firstly, your leverage works both ways. If SPY had gone down 10% to $360 then your losses would be very much higher:
- 50% strike: 20% loss
- 60% strike: 25% loss
- 70% strike: 33% loss
- 80% strike: 50% loss
- 90% strike: 100% loss
So, a 10% loss could wipe out your entire portfolio if you had a 90% strike. Makes you think twice, doesn’t it? Of course, unless it was a precipitous drop ITM would have got you out earlier, but sudden and steep drops do happen. Like the covid bear. That was a short and sharp bear market.
The Covid Bear
The ITM signal came when SPY was trading at $288, which was almost 15% below its recent high of $339. You can work out in your head what the percentages would be:
- SPY Shares: 15% loss
- 50$ strike: 30% loss
- 60% strike: 37% loss
Of course, SPY went down much further to $223, so holding the shares would have lost you 34% at the bottom of the bear. The only good thing about the covid bear is that is was over quickly. It reached its bottom in March but was making new highs by the end of August.
Time Value
The second thing to remember is time value.
The deeper in the money you go the less time value and the more intrinsic value you have.
If you buy OTM then the entire cost of the option is time value.
Let’s quickly review how to calculate the time value. We know that:
Options price = Intrinsic value + Time value
With some basic algebra we have the equation:
Time value = Options price – Intrinsic value
Time value is best expressed as a percentage. Here’s the formula:
Time %= ((Time value / Options Price) / Options Price) * 100
Let’s look at today’s pricing. With SPY trading at $579 we find the following options with March 2025 expiry:
- 50% strike ($290): $5.15 time value (1.75%)
- 60% strike ($350): $6.69 time value (2.84%)
Both of these are slightly above the ITM parameters, as today’s options are more expensive due to increased volatility and higher interest rates. We can reduce the time value by choosing a nearer expiry date:
- 50% strike ($290): $2.49 time value (0.85%)
- 60% strike ($350): $3.29 time value (1.38%)
The choice is always yours. The closer the expiry the more frequently we have to roll, but with a low time value you don’t have to time this as long as you do the selling of the old option and the buying of the new option at the same time.
Should we roll up or not?
That is your decision. If you bought a 50% strike and SPY has increases by, say 20%, then your option strike will now be at 42%, which means that you will not have the same leverage as you did when you bought it. If you want to keep the strike at the same level, then you need to roll up.
Whew!
A bit of number crunching here, which is quite boring I know, but important to understand. I hope I have explained it well enough!
To the markets . .
There were some big, non-tech earnings last week, but they did not move the market very much. It was a rather uneventful week, but, hey, I can live with that!
SPY Charts
It was a bit of a nothing week, with SPY trading sideways and slightly down. From the chart it looks like it is testing the $574 level (which was the high in September) for support. I can’t see anything ominous in that chart, but perhaps I shouldn’t say that – tempting fate!
On the longer term chart, the uptrend is well established.
SPYG Charts
SPYG is bouncing around at resistance level (the blue horizontal line). That’s the high is made in early July. Quite normal behavior, we’ll hope it breaks to the upside this week.
And on the longer term chart we see the uptrend still in place:
QQQ Charts
QQQ still hasn’t reached the high from early July, and has been trading sideways for the last month. Big tech start reporting this week so we might get a breakthrough. Hopefully.
And it is still crawling up the lower bound of the trading channel.
VIX Chart (Volatility)
The VIX is way off its lows, but still in low volatility territory.
ITMeter
The week ahead . .
It’s a big week for tech earnings, with five of the ‘magnificent seven’ reporting. Alphabet (GOOGL) on Tuesday, META and MSFT on Wednesday then AAPL and AMZN on Thursday.
That only leaves TSLA (who reported last week and the stock jumped 12%) and NVDA who will report on November 20th. If the earnings are strong then we could see breakouts in SPY, SPYG and QQQ. Let’s hope so.
The Futures
The futures look positive, presumably everyone is expecting some great big tech earnings. Let’s hope so!
No Blog Next Week
I am off gadding about again. It is the racing carnival in Melbourne, and I am pretty much booked up for the whole week, so I won’t have time to do the blog. I’ll be keeping an eye on the market, and if there is anything ominous, I will send out an email, but I am really not expecting anything to happen.
Just hoping the earnings are great and the market goes up!
Next blog will be on the 11th November.
Fingers crossed for a good week!
Heather
Q & A
31 Responses
Hi Heather. This is Andy again. Hope you had a great vacation. I figured out my problem with displaying 10 and 200 day SMAs on Tradingview charts. When you set up the SMA dialogue box you can select the calculation timeframe at the bottom of the inputs tab. If you select “Chart” it defaults to the interval on the selected time scale at the bottom of the chart. If you select “1 Day” the SMA will calculate for 1 day intervals for all chart scales. I took a screenshot but I can’t get it to paste on this blog entry. Thank you for responding to my message. I am learning a lot from you and I really appreciate it. Regards, Andy
P.S. I will try sending you the screenshot to your email address.
I have been working on an income version of your strategy. We have had many of the same experiences with trial and error. Thank you. I have your books. James
Hi James – you must be prescient! I am doing this and next week’s blogs on income strategies.
Would be very interested to see what you are doing and how it is working. Maybe you could start a chat on https://heathercullen.com/itm-chat/
h
Hello Heather, I noticed on the charting tool on the website the 200 SMA line changes depending on the time frame. With a shorter time scale like 1 day to 1 month the 10 day SMA crosses the 200 day several times. When I zoom out to 6 months or 1 year the 10 day line stays well above the 200 day line. This makes determining the crosses a little confusing. Any suggestions? Thank you, Andy
Hi Andy, I am having a bit of trouble understanding what you are seeing. If you have chosen the 10 DAY and 200 DAY SMAs their values will always be the same no matter what time frame the chart is, so the date of the crosses is always fixed.
I’ve been playing around with the charts, and can’t quite wok out what you are doing.
If you could send a couple of screenshots to info@heathercullen.com then I will have a look.
Hope this helps
h
I had the same problem at first until I realized that the moving Average changed with what time frame you chose at the bottom of the chart. For one year it is in days, when you change to 6 months it changes the SMA to 2 hours, if you pick 5 years it go to weeks etc. So if you go to the bottom of the chart and pick one year the SMA will be for one day, that is 200 day and 10 day. You can then use the scroll on your mouse to shorten or lengthen the time frame. Hope this clears it up for everyone/
Jim
Hi Jim,
just checking that I am understanding you – you have to follow the instructions at the top of the chart and specxifically set your SMAs to 10 and 200 – then it doesn’t matter what time frame your chart is, the SMA values will always be the same.
Have another look – here’s the link: https://heathercullen.com/stock-charts/
Hope this helps
h
Hi Heather,
I am setting the chart as per you instructions to 10 and 200 days and the drop down window to one day which makes the chart a one year chart. The problem is if you go down to the bottom left of the chart and change the chart to 6 months it changes the 10 and 200 time frame to 2 hours instead of 1 day. if you change the chart to 5 years it changes the 10 and 200 SMA to 10 weeks and 200 weeks.
Try changing the chart at the bottom to anything besides a year and look at the drop down menu and you will see that it changes too. I am sure this is what some people and doing to get the inconsistencies with the moving averages.
Just signing up for your newsletter. I have purchased the IYM book did my usual scan read now starting my second reading. So far my thought is wish I had found this 15 years ago.
Michael
Hi Micheael, welcome – and I wish I had worked it out 25 years ago when I started trading! It would have saved 15 years of pain and not much profit!
h
New to trading and read your three short books. I enjoy your approach and would like to start following you. Thank you for your insight.
Rob
HI Rob – glad to have you on board.
This blog is mainly based on the In The Money books – the ITM strategy, so I hope it makes sense to you! The ITM Bull Strategy is the relevant one at the moment, and fingers crossed that we don’t have to switch to the bear strategy any time soon!
h
Hi Heather,
Hope you’re enjoying your time in Melbourne! I just read your book, and currently, I don’t have any open ITM SPY positions. I’d love to hear your thoughts on purchasing ITM SPY when it’s at an all-time high of $591.93, with the 200 SMA at $535.95. The bull out price when 10 SMA cross below 200 SMA, would be around a 10% drop, or roughly $60.
At the moment, the strike 60% of the current price is 355, and the options price is 247.51 (DTE 225). Given this setup, doesn’t it seem quite risky? It looks like we could potentially lose over 20% of the premium on just this one trade. Looking forward to your insight!
Thanks,
Denis
HI Denis – yes, it is always with trepidation that you buy into a position – if the market is up then you wonder if it is going to keep going up, if it is down then you wonder if it is going to keep going down.
Unfortunately, none of us have crystal balls. Not that work, anyway.
The recent jump up to new highs is to be expected after the outcome of the election. Whether it is going to continue I don’t know – but then, neither does anyone else. I can only read charts, and I notice three things – 1. That the consolidation at the 580 level has been going on for more than a month (before the drop late last week) and 2. Before that the support level (at the July high) has held for 2 months and 3. We are approaching 600 – which may be a psychological barrier.
My expectation is that tonight a lot of people will be taking profits (T+3) so I don’t expect another rise tonight, but hopefully I am wrong.
How long this bull run is going to last I don’t know – but bull markets tend to last longer (4 – 6 years) than bear markets (9 – 13 months). You might want to have a look at some previous blog posts about this – just google Joining the Bull Run – Heather Cullen : In The Money Online and Riding the Bull – Heather Cullen : In The Money Online.
Thank you so much for your feedback! I really appreciate it, and I’m looking forward to diving into your blog posts—I’m sure I’ll find a lot of valuable insights there.
I’m trying to find the backtesting page but the link from the book redirects to the blog page. Any updates? Thank you!
James
HI – if you lookm at the footer there is a link to the backtesting. I’ve just tried it and it works.
h
Hi Heather,
I hope you are doing well. I love the weekly blog posts and have enjoyed reading them and getting a quick refresher on the ITM strategy.
I was wondering if you have ever sold a covered call against the ITM options for extra money? What are your thoughts on doing this? Even if the ITM option got called away it would still be a gain because of SPY going up over time. I wouldn’t do the wheel strategy I would just buy another ITM option and then sell another covered call against this. I remember reading in one of your books you weren’t a big fan of the wheel strategy either. I read all your stuff via Kindle Unlimited, so I can’t remember which book it was.
Does this make sense? Is it a viable strategy or would it be better to just stick to buying and holding ITM SPY options?
Look forward to hearing your thoughts. Have a great week!
Cheers!
—
Zander
Hi Zander
I think selling covered calls on your ITM options sounds good in theory – I just can’t get it to work out in practice! The payback is just too low, and (in my opinion) not worth the effort.
Looking at today’s prices we have SPY at $582.77. If we decide to sell a 1 week to expiry call 2% above current price the bid / ask is $0.37 / $0.42 so the mid point is around $0.40. This means that by selling this call we will get the princely sum of $40. On a 50% strike option this is a 0.137% return, or 6.86% per year. Given that on some weeks SPY goes up more than 2% you are forfeiting these gains for the weekly $40 payment.
I know that covered calls have a good following, and they are touted as a safe way to trade. Maybe they work for some, but I have never been able to make them work for me. I’ve looked at all sorts of combinations and modelled them – always the payback is just too low.
Re the wheel strategy – also seductive, sounds good – but in my opinion it doesn’t work. You miss out on too much for very paltry gains.
Hope this helps
h
Thank you for your response! When you say you miss out on too much with the wheel strategy are you referring to the gains? I’m just curious what you mean. I’m assuming that ITM just makes you more money? I haven’t run the wheel strategy before. Thanks.
Hi Heather, Thanks for being available for advice, btw! It looks like the last golden cross in SPY occurred around November 7th of 2023. Presently the spread between the 10d sma and the 200d sma is about 50 points. So the next signal would have to be the death cross, and it looks like that barring something very dramatic that should take some time. Am I seeing things right?
Hi Robert, yes the last golden cross was Nov last year and the next signal will be the death cross – but let’s hope that it is some time away!
As you have noticed, there’s a big gap between the 10 & 200 SMAs – 582 and 533 respectively, a large gap. As you say, something very dramatic would have to happen for there to be a cross in the near future.
Let’s hope that doesn’t happen!
h
Thanks for your response, Heather. The point I was trying to make is that, since the next signal would have to be the death cross, it’s time to study up on the bear market strategy and just have patience!
HI Robert – there is no reason not to jump into the market as long as a bull signal is in force – which it is. If you wait for a death cross and then a golden cross you could be waiting a long time, possibly years!
I did a blog post on it earlier this year -‘Riding the Bull’ – here is the link: https://heathercullen.com/leverage-strikes/#comment-1377
Of course, the ITM backtesting has been done on a golden cross entry and a death cross exit, and you have already missed a year of the bull run – but it can go a lot longer than people think.
Hve a look at Riding the Bull and then make your decision.
Hope this helps
h
Thanks for clarifying!
Dear Heather,
Thank you for your weekly blog as always. Reading your weekly blog is like reading the annual report of Berkshire Hathaway. It offers me a lots of insights of how the stock market behaves. I am currently vacationing in Hawaii and in early November, the USA presidential election is happening. Hopefully, it will be decided quickly and will not be a repeat of controversial presidential elections in 2020 between Biden and Trump and in 2000 between Bush and Gore.
Sincerely,
George Halongton
I haven’t been in Hawaii for years – have a lovely time!
Yes, I wish the election was over and done with so that we could have some certainty. Fingers crossed!
h
Hi Heather, enjoy the break.
Thank you!
h
Enjoy your vacation!
Thank you!
h