## 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 20^{th}. 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 11^{th} November.

Fingers crossed for a good week!

Heather

## 14 Responses

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

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

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