Strategy

dragon leap

Type of Strategy

investing

sentiment

bullish

implied volatility

low iv preferred

description

For Long-Term Investment Only:

Rather than purchasing stock outright or as a stock substitution, a dragon leap strategy provides an alternative to reduce the use of cash for the stock position.

The Dragon Leap strategy is an essential tool for long-term option investing.

Set-Up

Purchase a DITM 95-99 delta LEAP call option for long-term investment with extrinsic value E1.

Sell a OTM 1-20 delta 25-50 DTE call option with extrinsic value E2 such that   {E2>E1}

Invest the cash saved in a very low-risk vehicle to boost financial returns.

example

Investor has 100 shares of Micron Technologies (MU) and wishes to use options in a stock replacement strategy.  MU currently priced at $85/share.

1) Sell 100 shares of MU at $85/sh for $8,500 cash proceeds.  (Note tax impact)

2) In an offensive account (tax-free), purchase a 365 DTE, 95 delta call option with strike price of $40 for $46.13 (E1 = $1.13)

3) In the offensive account (tax-free), sell a 30 DTE, 18 delta call option with strike price of $98 for $1.16 (E2 = $1.16).

4) Net cash usage for the position is $46.13-$1.16 = $44.97/sh, or ~$4500.

5) Considerations:  E2>E1  $44.97 < ($98-$40 = $58)

6) IMPORTANT: Notional Consideration: Even though cash investment is only $4,500, this equity should be managed at full notional exposure of $8,500.

7) Cash savings from dragon leap = $8,500 – $4,500 = $4,000.

8) Account holder invests $4,000 in a defensive account (Index Mat example)

A. Sell an SPX 180 DTE put vertical at the 3-delta level which is 40% below current SPX market value.  This spread has an annual yield of ~4.5%.

B. SPX index options receive preferential tax treatment as Section 1256 contracts.

C. Account holder must roll SPX put verticals at ~180 days for continued returns

D. After-tax financial return on SPX spreads is approximately $136

7) $136 return on 100 shares MU = $1.36 per share

8) $1.36 / $85.00 = +1.6%

9) Benefit of stock substitution strategy is approximately 1.6%

management

If stock price rises significantly after employment of dragon leap, investor may need to roll out the covered call.

If stock price rises well above the short strike, investor may need to close the diagonal for a profit and institute a new dragon leap.

Based on the duration of the LEAP option, the investor may need to roll out the LEAP every 1-2 years (hence the benefit of a tax-free account).

Implied volatility levels may require occasional covered calls to cover extrinsic value of LEAP when rolling.

Dragon Leap: MU at Short Strike Expiry

Dragon Leap: MU at LEAP Expiry