I'm pondering whether I should long some of my RIMM via options (or LEAPS). My experience with derivatives is limited.
So, here is a question to everyone: How should I size my position? And more importantly, how much out of money, and at what expiry date? I'm interested in using it as a risk control. I'm interested in the principles and reasoning.
Thanks.
(Disclosure: Long RIMM)
I'm absolutely no expert in this but have been giving this a lot of thought too. The conclusion I came to was LEAPs are appropriate if your see the possibility of a complete loss in an equity position (maybe due to over leverage of the underlying company) and where there is a catalyst that will prove your thesis right or wrong within the LEAP time frame. This way, your downside is the same (a potential complete loss) however you have leveraged the upside to make a more favourable asymmetrical bet. As for position size, I'd keep it the same as for an equity position given those same characteristics (leverage+catalyst) and almost certainly less than 10% of your portfolio, probably closer to 5%. This all more or less agrees with Joel Greenblatt's opinion in his book You Can be a Stock Market Genius. If you haven't read the LEAPs section in that - get a hold of it, it's well worth your time.
ReplyDeleteThanks Graham. I have the same line of thinking. (I've read Greenblatt's book. Definitely one of my favourites.)
DeleteSince options/LEAPS are intrinsically leveraged, I think the position has to be much small.
What I'm struggling with is: with shares, there is only one variable, the price. With options/LEAPS, there are three: price, strike price and maturity. I don't have a clear framework to select them.
Maturity: if you are not betting on a specific event I would go for the options with the longest maturity. Otherwise you only incur transaction costs rolling over your position.
ReplyDeleteStrike: Depends on how much leverage and risk you want. You just need to size your position down when you go for higher strikes since the probability of a zero increases.
I would by the way just go for an simple position in the equity itself, especially when you invest in something like RIMM. Does have plenty of leverage on it's own (and options are also more expensive because of the higher beta)
Thanks AV. That's most helpful.
DeleteAs an objective measure of position sizing for an all-or-none investment like an option, one reasonable choice is the Kelly criterion (best described in the book Fortune's Formula by William Poundstone).
ReplyDeleteAgree. Certainly (fractional) Kelly is the way to go.
DeleteBy memory Greenblatt recommends a strike price no more than a few strikes above where the stock trades at currently (assuming you think it is currently undervalued). I can't remember his reasoning haha. And the longest time period (unless a certain catalyst occurs significantly within the 2 or so years).
ReplyDeleteThanks Graham.
DeleteDoes anybody know how Greenblatt came up with this rule of thumb?
I am also pretty bullish on the stock and can well imagine that it could double or even treble from here if BB10 is a success. However, the options look expensive in my view. For example, I just looked at the January 2015 call with a strike of $25 - the premium is $3.75 (or 20% of the current price of $18) and the implied volatility is 57%. That seems a lot for a option that is still quite a way out of the money - so even though I think buying options could pay off in this case I am not sure they are really cheap, I just opted to buy the stock.
ReplyDeleteSorry I read your posts backwards, I agree that there is no longer a margin of safety in the stock, saying that I am going to let my position run because I think there could be significant upside, and if BB10 is a flop the assets will get sold for maybe $8-10. So limited downside and potentially significant upside, to me that has huge in-built optionality so long as you bought below $10 and are willing to risk your profits, and in my opinion is a better option than buying calls (but in terms of sizing a call position the option premium is 20$ or 5x leverage so you would want a position size of 20% of your full stock position. Obviously that varies depending on the strike etc..
DeleteAll good points. Thanks.
DeleteHow are leaps different to warrants?
ReplyDeleteLooking to use leaps in aust, but we dont have any, only options on bigcaps and warrants on a few midcaps and no derivatives on the majority of stocks...