Measuring the LEAPS Perpetual Income Strategy

This is a continuation of a series of articles on my customized, all-weather, high yield LEAPS Perpetual Income Strategy.

You can find the full series here.

If you're up to speed on constructing and then managing the trade, then it's time we look at measuring the trade.

And this is a key component of the strategy.

It's not only critical to understanding how and why the strategy works, but it also lets us know, at any point in time, exactly how profitable the trade is.

(One of the inconveniences of working with LEAPS based calendar spreads is that - thanks to the wide bid-ask spreads associated with LEAPS - it's often a challenge determinging an accurage fair value of your position.)

The Brilliant Way to Accurately Measure the Performance and Health of the Trade

Before we look at a couple of trades, let's talk about how best to track and measure them.

And this is a perfect example of discovering something in the real world that never would have revealed itself in the lab.

As you recall, we buy our LEAPS deep in the money in order to pay as little extrinsic or time value as possible.

(Remember, the option with the highest amount of time value will always be the one closest to the current share price.)

While the overall intrinsic value of our long call LEAPS combined with our long put LEAPS is guaranteed to never decrease, it's important to recognize this:

We WILL have to recoup all the extrinsic/time value of our long LEAPS before we can ensure that the trade is profitable at the end of the day.

But instead of determining what that figure is and then holding our breath until we've accumulated enough net premium income from selling multiple legs of near dated options to exceed that figure, I came up with a far superior - and way more insightful - way to assess these trades.

While the "consider it red until it turns black" approach will work, it's too much of a back loaded process.

And it's also imprecise.

It tells us nothing about how fast or how slow the income we're generating is filling up our initial deficit.

Only one metric does that . . .

Annualize It!

I really love annualizing things. I compare it to a speedometer. It tells you how fast (or slow) something is happening.

In this case, we can annualize - and clock - two key components of our trades:

>> The time/extrinsic of our long LEAPS

Think of the extrinsic value on our long LEAPS as a nuisance tax, surcharge, shakedown, or commission we have to pay Mr. Market to set up our trade.

Instead of trying to recoup that amount all at once - or before we do anything else - we can annualize the prorated amount over the projected life of the trade (i.e. when our LEAPS are scheduled to expire).

This gives us a unique and powerful perspective on the trade.

It tells us the precise speed at which we'll need to book our option income in order to ensure the trade is profitable.

>> Our near dated short options

The next step is to simply annualize the premium income our short options are producing.

We take our net premium collected from our short option positions, divide that by the intrinsic value of our long LEAPS, and then convert it into an annualized rate.

Presenting . . . The Profitability Spread

Once we have these two annualized rates calculated, it's super easy to look at the "spread" between them and see in an instant precisely how well the trade is performing.

As long as the annualized rate of the net premium we collect on our short options exceeds that of the annualized rate of the Nuisance Tax (i.e. extrinsic value) on our long LEAPS, we know whether, and the degree to which, we're profitable.

Next, let's take an objective look at the pros and cons of the LEAPS Perpetual Income Strategy.

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Warren Buffett Zero Cost Basis Portfolio Current Equity Holdings:

KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares

Open Market Purchase Price: $20,071.83

Less Booked Option Income: $16,341.71

Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%